How to Calculate the Equivalent Annual Rate (EAR): A Guide for Investors and Borrowers

EAR

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EAR stands for Equivalent Annual Rate, which is the interest rate that would make a series of uneven cash flows or investments equal to a single, fixed return. It is also known as the Annualized Rate of Return.

The EAR is useful when comparing investment and loan options that have different compounding periods or payment frequencies. By converting varying cash flows to an equivalent annual rate, it makes it easier to compare and evaluate different investment options.

To calculate the EAR, you would first need to determine the periodic interest rate (PIR) and the number of compounding periods (m) per year. The formula for calculating the EAR is as follows:
EAR = (1 + PIR/m)^m – 1

For example, if a loan has a PIR of 2% and compounds monthly (m = 12), the EAR would be:
EAR = (1 + 0.02/12)^12 – 1
EAR = 2.02%

This means that if you were to repay the loan in monthly installments, with a 2.02% monthly interest rate, the total cost of the loan would be equivalent to a single, fixed annual rate of 24.56% (calculated by multiplying the EAR by 12).

Calculating the EAR is important as it helps investors and borrowers to make informed decisions about which investment or loan option is the most cost-effective over the long term.

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