Overview of the effect of compounding and equivalent annual rate (EAR)
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02:15 – The formula for the Effective Annual Rate (EAR)
04:30 – EAR for different compounding periods
07:45 – Calculate the Periodic Interest Rate starting from the EAR
09:35 – Conclusions
When we are using different discounting periods than the standard yearly period, we see that when we compound over one year the total compounded interest is higher than the annual interest we started from.
This is because compounding is not linear but a power function and the smaller the compounding period the larger the difference.
Based on the original interest and the compounding period it is possible to calculate an equivalent yearly interest rate which is the equivalent annual rate (EAR) sometimes also called the effective annual interest rate.
For investments, it is always necessary to know the EAR and the formulas are rather simple as you can see in the video.
Another approach is that we start from the Equivalent Annual Rate (EAR) and we want to determine the periodic interest rate that corresponds with it. In that case, we have to conduct the inverse calculation.