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When googling for Effective rates, i'm getting a different result for the formula compared to what we are using in our current company.

Google Result: Effective Annual Rate(EAR) = ((1+i/n)^n)-1

where i = annual interest rate

n = Compounding Periods

For Example for Quarterly EAR = ((1+.1/4)^4)-1

EAR = 10.381%

Company Formula Effective Rate = ((1 + Nominal_rate/Npery)^Npery)-1 where

Nominal_rate = annual rate / 12 if monthly; annual rate / 4 if quarterly

Npery = 12/x where x = 12 if Monthly; x = 4 if Quarterly

For Example For a Quarterly payment frequency and a 10% rate

Nominal Rate = 10%/4 = 2.5%

When using the company formula

Npery = 12/4(since Quarterly) = 3

Effective Rate = ((1 + 0.025/3)^3)-1

Effective Rate = 2.521%

The question is, which one is more appropriate to use?

MagsTester
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1 Answers1

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I do not understand your implementation of the company method.

If the nominal annual rate is $10\%$ and gets applied as $2.5\%$ charged at the end of each quarter (so four times a year) then I would have thought

  • Npery $=4$
  • Nominal_rate $=10\%=0.1$
  • Nominal_rate/Npery $=2.5\%=0.025$
  • EAR =((1 + Nominal_rate/Npery)^Npery)-1 $= ((1 + 0.1/4)^4)-1 \approx 0.10381 =10.381\%$

as in your initial calculation. An Effective Annual Rate of about a quarter of the nominal annual rate is implausible.

Henry
  • 157,058
  • Hi thank you for your reply. Npery as per formula was = 12 / x... where x is 12 if Monthly and 4 if Quarterly in my case since quarterly, 12 / 4 = 3. Npery = 3 – MagsTester Feb 16 '23 at 12:18