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Interest Rates

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Effective Interest Rates

Effective Annual Interest Rate - Interest rate


that is annualized using compound interest

Annual Percentage Rate - Interest


rate that is annualized using
simple interest
Effective Annual Rate
Interest rates are often stated as an EAR
which indicates the total amount of
interest that will be earned at the end of
one year. We use the EAR in our time value
of money calculations as the dicount rate,r
.
It considers the effect of compounding
The EAR increases with the frequency of
compounding because of the ability to
earn interest on interest sooner.
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Be careful
Earning a 5% return annually is not the
same as earning 2.5% every six
months.

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Annual Percentage Rates
Banks also quote interest rates in terms of APR,
which indicates the amount of simple interest earned
in one year, that is the amount of interest earned
without the effect of compounding. Because it does
not include the effect of compounding, the APR quote
is typically less than the actual amount of interest
that you will earn. To compute the actual amount
that you will earn in one year, the APR must first be
converted to an effective annual rate.

EAR = (1 + APR/m)m 1
APR does not reflect the true amount you will earn
over one year

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EAR & APR Calculations
Annual Percentage Rate (APR):
APR MR 12 *where MR:
monthly interest rate
Effective Annual Interest Rate (EAR):
EAR (1 APR / m) 1
m

To convert a discount rate of r for


one period to an equivalent discount
rate for n periods:
Equivalent n-Period Discount
Rate= (1+r)n - 1 6
Example

Suppose a bank offers you an automobile loan at


an annual percentage rate, or APR, of 12% with
interest to be paid monthly.

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Example

Your firm needs to invest in a new delivery truck.


The life expectancy of the delivery truck is five
years. You can purchase a new delivery truck for
an upfront cost of $200,000, or you can lease a
truck from the manufacturer for five years for a
monthly lease payment of $4000 (paid at the end
of each month). Your firm can borrow at 6% APR
with quarterly compounding.
a) The effective monthly discount rate that you
should use to evaluate the truck lease is closest
to:
b) The present value of the lease payments for the
delivery truck is closest to:

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You are considering purchasing a new automobile
that will cost you $28,000. The dealer offers you
4.9% APR financing for 60 months (with
payments made at the end of the month).
Assuming you finance the entire $28,000 and
finance through the dealer, your monthly
payments will be closest to: