What Is the Difference Between APR and EAR?
Uncover the real cost of borrowing and the actual return on savings. Learn why APR differs from EAR, revealing your true financial picture.
Interest rates are a fundamental component of personal finance, influencing both the cost of borrowing and the potential for savings growth. However, their presentation can lead to confusion. Understanding these distinctions is important for informed financial decisions. This article aims to clarify two common terms: Annual Percentage Rate (APR) and Effective Annual Rate (EAR).
Understanding Annual Percentage Rate
The Annual Percentage Rate (APR) represents the yearly interest rate charged on borrowed money or earned on an investment. It is expressed as a percentage and provides a standardized way to compare the cost of credit. APR often includes the nominal interest rate along with certain fees associated with the loan, such as origination fees or discount points, reflecting the total borrowing cost. However, it does not account for the effect of compounding interest within that year.
For instance, when considering a car loan or a mortgage, the lender will quote an APR. If you borrow $10,000 at an APR of 6% for one year, you would pay $600 in interest over that year. This calculation assumes a simple interest application, where interest is only applied to the original principal amount. Credit card APRs also indicate the annual interest rate, typically without additional fees.
Understanding Effective Annual Rate
The Effective Annual Rate (EAR), sometimes known as the Annual Equivalent Rate (AER) or Annual Percentage Yield (APY) for savings, reflects the true annual rate of interest. This rate takes into account the impact of compounding over the year. Compounding refers to the process where interest is calculated not only on the initial principal but also on the accumulated interest from previous periods. This means interest earns interest, leading to a higher overall return or cost.
EAR provides a more accurate representation of cost or return because it incorporates the frequency of compounding. For example, if a savings account offers a 5% nominal interest rate compounded monthly, the interest earned each month is added to the principal, and subsequent interest is calculated on this new, larger balance. This monthly compounding results in an EAR that is slightly higher than 5%, providing a clearer picture of earnings. It is important for evaluating financial products where interest accumulates more frequently than once a year.
Comparing APR and EAR
The fundamental difference between APR and EAR lies in their treatment of compounding interest. APR presents the simple annual interest rate, which may include certain fees but disregards the effects of compounding within the year. In contrast, EAR provides the true, compounded annual interest rate, reflecting the actual cost or return with frequent interest calculation. This distinction impacts the financial outcome.
For loans, the EAR will be higher than the quoted APR if interest compounds more frequently than once a year. For example, a loan with a 12% APR compounded monthly means the interest is calculated twelve times a year, leading to an EAR of approximately 12.68%. This indicates the true borrowing cost is higher than the advertised APR.
Conversely, for savings accounts, an EAR will be higher than the nominal rate due to compounding, meaning the actual return is greater than the simple annual rate. For instance, a savings account with a 5% nominal rate compounded daily could yield an EAR closer to 5.13%. Understanding the EAR is important as it offers the most accurate measure of total cost or return.