Why EAR matters
Different lenders quote interest using nominal rates and a compounding schedule (monthly, daily, quarterly, etc.). EAR standardizes those offers into a single annual rate so you can compare the real cost of consumer and business loans. That makes EAR especially useful when one loan shows a lower nominal rate but compounds more frequently.
How to calculate EAR (formula and steps)
Formula: EAR = (1 + i/n)^n – 1
- i = nominal annual interest rate (decimal)
- n = number of compounding periods per year
Worked example (6.0% nominal, compounded monthly):
- Convert the nominal rate to decimal: i = 0.06
- n = 12 (monthly)
- EAR = (1 + 0.06/12)^12 – 1 = (1 + 0.005)^12 – 1 ≈ 0.061677
- EAR ≈ 6.17%
Practical comparison example
Loan A: 5.9% nominal, compounded daily (n = 365)
Loan B: 6.0% nominal, compounded monthly (n = 12)
Calculate EAR for each to see which carries the lower true cost — the lower EAR is the better choice all else equal. (Note: EAR measures interest compounding only; it does not include fees.)
EAR versus APR and fees
EAR measures only how interest compounds. APR (annual percentage rate) generally attempts to include certain fees and finance charges in a single number for consumer disclosure. For decisions where fees matter (origination fees, points, or recurring service charges), compare APRs and total costs in addition to EAR. See our guide on EAR vs APR and advice on comparing loan offers.
When to use EAR
- Comparing loans with different compounding frequencies (monthly vs daily)
- Evaluating investments or savings products where compounding matters
- Converting a quoted nominal rate into a true annualized rate for budgeting
When EAR is not enough
EAR does not capture lender fees, prepayment penalties, or non-interest costs. For consumer loans, federal disclosure rules require APR to reflect many costs — review both EAR and APR and read the loan disclosure carefully. For complex business financing, run total-cost cash-flow comparisons (including fees and covenants).
Professional tips
- Always compute EAR when compounding schedules differ; a small percentage difference compounds significantly over multi-year loans.
- Ask lenders to explain whether quoted rates are nominal or effective and whether fees are included in any advertised APR.
- Use a spreadsheet or calculator and save the calculations when negotiating.
Common mistakes to avoid
- Assuming a lower nominal rate always means lower cost.
- Ignoring fees and focusing solely on EAR—fees can outweigh small EAR differences.
- Forgetting to compare APRs for consumer protection disclosures.
Sources and further reading
- Consumer Financial Protection Bureau — consumerfinance.gov (explains APR disclosures and shopping for credit)
- Investopedia — Effective Annual Rate: https://www.investopedia.com/terms/e/effectiveannualrate.asp
A quick professional note
In my experience advising borrowers, EAR is the fastest way to spot when a seemingly attractive nominal rate is misleading because of frequent compounding. But for consumer protections and fee transparency, always review the APR and the loan’s written disclosures.
Disclaimer
This article is educational only and does not constitute personalized financial or legal advice. For decisions tied to your personal or business finances, consult a licensed financial advisor or attorney.
