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What is Annual Equivalent Rate mean?
The effective interest rate (EIR), effective annual interest rate, annual equivalent rate (AER) or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate and expressed as the equivalent interest rate if compound interest was payable annually in arrears.
It is used to compare the interest rates between loans with different compounding periods, such as weekly, monthly, half-yearly or yearly. The effective interest rate sometimes differs in one important respect from the annual percentage rate (APR): the APR method converts this weekly or monthly interest rate into what would be called an annual rate that (in some parts of the world) doesn't take into account the effect of compounding.
By contrast, in the EIR, the periodic rate is annualized using compounding. It is the standard in the European Union and many other countries around the world.
The EIR is precise in financial terms, because it allows for the effects of compounding, i.e. the fact that for each period, interest is not calculated on the principal, but on the amount accumulated at the end of the previous period, including capital and interest. This reasoning is easily understandable when looking at savings: if interest is capitalized every month, then in every month the saver earns interest on the entire sum, including interest from the previous period. Thus if one starts with $1000 and earns interest at 2% every month, the accumulated sum at the end of the year is $1268.24, giving an effective interest rate of about 26.8%, not 24%.
The term nominal EIR or nominal APR can (subject to legislation) be used to refer to an annualized rate that does not take into account front-fees and other costs can be included.
Annual percentage yield or effective annual yield is the analogous concept used for savings or investment products, such as a certificate of deposit. Since any loan is an investment product for the lender, the terms may be used to apply to the same transaction, depending on the point of view.
Effective annual interest or yield may be calculated or applied differently depending on the circumstances, and the definition should be studied carefully. For example, a bank may refer to the yield on a loan portfolio after expected losses as its effective yield and include income from other fees, meaning that the interest paid by each borrower may differ substantially from the bank's effective yield.
referencePosted on 28 Sep 2024, this text provides information on Miscellaneous in Accounts and Finance related to Accounts and Finance. Please note that while accuracy is prioritized, the data presented might not be entirely correct or up-to-date. This information is offered for general knowledge and informational purposes only, and should not be considered as a substitute for professional advice.
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