Effective annual rate (EAR).
In plain English
The effective annual rate converts a stated annual rate into the rate a balance really earns or pays after compounding within the year. A stated rate ignores the fact that interest added in month one earns interest in month two. The more often interest is applied, the wider the gap between the stated rate and the effective one. EAR is the number that makes two offers with different compounding schedules comparable, which is why deposit accounts are quoted with an annual percentage yield.
01Why it matters
Two accounts or two loans quoting the same rate can cost or pay different amounts, and the effective rate is the only figure that puts them side by side honestly.
02The math, step by step
A stated 12 percent compounded monthly works out to (1 + 0.01)^12 - 1 = 12.68 percent. On a 5,000 dollar balance that is 634 dollars a year rather than the 600 dollars the stated rate suggests, a 34 dollar difference from compounding alone.
Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.
03What this is NOT
It is not APR. APR on a loan adds certain fees to the stated rate but generally does not account for compounding within the year. EAR accounts for compounding but not fees. A high-fee loan can show a higher APR and a lower EAR than a fee-free one.
04Receipts
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Plain-English answers from our glossary. Receipts included. Never advice.
Educational tool. Answers come only from ClearMoneySchool's published glossary and are not advice. Why we never give advice