Effective Annual Rate (EAR)

A stated or nominal rate does not tell the whole story when interest compounds more than once a year. The effective annual rate converts that stated rate into the rate you actually pay or earn over a full year.

Consider a credit card that charges 18% a year, compounded monthly. Each month, 1.5% interest is added to the balance. Because each month's interest is then charged interest in later months, the true cost over a year is about 19.56%, not 18%.

The more often interest compounds, the bigger the gap between the stated rate and the effective rate. With yearly compounding, the two are equal. With monthly or daily compounding, the effective rate is higher.

The EAR is useful for comparing products that compound differently. A loan quoted at 12% compounded monthly, with an effective rate of about 12.68%, is more expensive than one quoted at 12.5% compounded yearly. For savings, the same calculation is usually called the annual percentage yield.