Effective Annual Rate (EAR) vs. Nominal Rate: Meaning and Key Differences

While applying for a loan, the applicable rate of interest is one of the key factors that are taken into consideration. Usually, the option with a lower rate of interest is usually preferable, but this is not the only thing you need to pay attention to.

Table of Content

What Is the Effective Annual Interest Rate?
What is the Nominal Interest Rate?
Effective Annual Rate vs. Nominal Rate
Final Words

Nowadays, financial institutions use terms like 'effective annual rate' and 'nominal rate' while providing information about a loan scheme. These terms are closely related but indicate two entirely different things. To make an informed decision, you should have enough clarity about the meaning of 'effective annual rate' and 'nominal rate' and how they are different from each other.

What Is the Effective Annual Interest Rate?

The effective annual interest rate, commonly referred to as EAR, is the actual interest rate that is applicable to a financial product. Whether it’s an interest-bearing investment or any kind of loan, the total amount of interest is calculated using this percentage. The effective annual interest rate is sometimes called the effective rate or the annual equivalent rate (AER).

The following formula is used to calculate the effective annual interest rate:

Effective Annual Interest Rate = (1+ i/n)ⁿ - 1

Here, i is the nominal interest rate and n is the number of compounding periods.

The effective annual rate, or EAR, usually provides a more accurate calculation of the accrued interest because it accounts for the compounding effect.

More frequent compounding periods often lead to a higher effective interest rate. For example, you’re applying for a personal loan, and there are two different options with the same interest rate. While one compounds once in a year and the other one compounds twice in a year.

In such a case, the effective annual interest rate will be higher for the one that compounds twice a year.

What is the Nominal Interest Rate?

The nominal interest rate can be defined as the percentage using which interest will be calculated for a loan. It is also known as the stated rate of interest because it is the percentage that is initially quoted. Nominal interest rates are usually expressed annually, and they are not adjusted for inflation.

Effective Annual Rate vs. Nominal Rate

Here is a detailed comparison between the effective annual rate and nominal rate on the basis of several factors:

Aspect	Effective Annual Rate	Nominal Rate
Definition	The actual interest that you have to pay over a year, considering compounding	The stated interest rate for a year and does not account for compounding
Calculation	Calculated considering compound interest on the principal and accumulated interest	calculated using the principal amount
Compounding Frequency	Varies based on how often interest is compounded (monthly, quarterly, etc.)	Remains constant regardless of the frequency of compounding
Relevance for Decision Making	Gives an exact calculation of accrued interest	Doesn’t give a clear idea of accrued interest
Usage	Used to calculate the true cost of loan	Often used in initial quotes

Final Words

While the nominal rate indicates the stated interest rate for a financial product, the effective annual rate also factors in the effect of compounding. However, EAR has several limitations as well. For example, it is based on the assumption that the interest rate for a loan will be constant throughout the entire period. But in reality, interest rates experience significant fluctuations, and it impacts the overall loan repayment amount.

For better financial planning, it is important to have a clear understanding of these two rates and how they affect your debt. While obtaining a loan, this will help you calculate the accrued interest more precisely.

At Muthoot Finance, we offer quick and hassle-free personal loans at highly competitive interest rates. To apply for a personal loan, you can reach out to our team and submit your application online. Or, you can also visit your nearest Muthoot Finance branch for more information.