Effective annual rate

The effective annual rate — sometimes abbreviated to EAR or called the annual effective rate — is the interest rate an investment or loan actually achieves over a year, after accounting for the effect of compounding frequency. It is the figure that allows products with different compounding intervals (monthly, quarterly, daily) to be compared on a single basis.

Why it differs from the nominal rate

A loan or deposit that quotes a “nominal annual rate” of 6% compounded monthly does not actually grow at exactly 6% over a year. Each month, the balance earns 0.5% interest on the prior month’s balance, including interest already earned. The compounding within the year produces a slightly higher effective rate than the nominal figure suggests.

The formula:

Effective rate = (1 + Nominal rate ÷ Periods)^Periods − 1

For 6% nominal compounded monthly:

EAR = (1 + 0.06 ÷ 12)^12 − 1 = 6.17%

The 0.17% gap between nominal and effective is the value of within-year compounding. The gap grows with both the nominal rate and the compounding frequency.

How compounding frequency affects the gap

For a 10% nominal rate:

• Annual compounding: EAR = 10.00%
• Quarterly compounding: EAR ≈ 10.38%
• Monthly compounding: EAR ≈ 10.47%
• Daily compounding: EAR ≈ 10.52%
• Continuous compounding: EAR ≈ 10.52%

The shift from annual to monthly compounding adds roughly 0.5%, then continued increases in frequency add little. For practical purposes, daily and continuous compounding are nearly identical.

Why it matters

When comparing products, the nominal rate alone can mislead. A loan quoted at 5.95% compounded daily and another at 6.00% compounded annually are nearly identical in true cost — the daily-compounded loan’s effective rate (≈6.13%) is higher than the annual-compounded loan’s effective rate (6.00%) despite the lower headline nominal.

For deposit and investment products, the same principle applies in reverse: a higher effective rate means more growth, regardless of the nominal rate quoted.

The effective rate is the apples-to-apples figure for cross-product comparison. Where products are required to disclose comparison rates or APRs, those figures incorporate the effective rate effect along with fees, providing the cleanest single number for comparison.