In order to be smart and calculative in personal finance matters, understanding the time value of money is an essential part of the learning process. I will be posting a series of computation methods related to time value of money on every Wednesday.

Today, we will learn to calculate the actual **effective annual rate (EAR)**.

## Common Problems

If you have deposit money in a Fixed Deposit (FD) account, most like you was asked about the term of your deposit – 1 month, 3 months, 6 months, 1 year or longer? The bank gives different rate for different tenure. Let’s say Maybank is giving 3.7% for 12 months FD, and 3.4% for 6 months FD, what is the EAR for 6-months FD? Is it better than 12-months FD?

## Theory

**Scenario 1 – 12-month FD**

Referring to the situation above, let’s say you are depositing RM10,000 in FD for 12 months tenure. At the end of the term, you will get your initial investment (RM10k) plus the 3.7% interest (RM370)

Return = **3.7% p.a.** , which is also the EAR.

**Scenario 2 – 6-month FD**

If you opt to put the money in 6-months FD, after 6 months, you will get

Return = 3.4% x (6/12) = 1.7% , which is equal to RM170 interest earned.

Then you renew the FD without withdrawing the interest earning, you will have RM10,170 in the FD for another 6 months.

At the end of the year, your will get another earning of 1.7% x RM10,170 = RM172.89.

So your total return is RM170+RM172.89 = RM342.89

The Effective Annual Rate (EAR) = RM342.89/RM10,000 = **3.4289%**

To easily calculate the EAR, use the formula below:

where *i* = nominal annual rate (normally stated); * n* = number of compounding period (compounding frequency);

For the above example

EAR = [(1+ 0.034/2)^2] – 1

= **3.4289%**

## Nominal Interest Rate

Photo by wmjas

Nominal interest rate is what we usually see on financial products. Most of the time, these rates may not be the actual annual rate.

An interest rate is called *nominal* if the frequency of compounding (e.g. a month) is not identical to the *basic time unit* (normally a year).

Example:

- interest rate on housing loan (EAR is higher when it is daily rest)
- published FD rates for different terms (1 month, 2 months, or 12 months etc)

The more frequent you compound, the higher the EAR.

When you want to compare plans, first you must calculate the respective EAR for each plan. Then compare the EAR.

Use this EAR convertor

## Exercise

You have RM7,000 in Fixed Deposit with CIMB Bank. Your FD is renewable every month and CIMB bank provides 3.2%p.a. interest. You let the FD renewed for 2 years. From the 3rd year onwards, the bank lowered the FD interest rate to 3.0% p.a. But you don’t need the money, so you leave it there for another 3 years. What’s the final amount you will be able to withdraw at the end of 5 years?

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## Previous Tutorial on Time Value of Money

How to calculate the value of single sum investment {Time Value of Money Tutorial}

Finding the Rate of Return to Meet Financial Goals {Time Value of Money Tutorial}

Computing the Value of a Fixed Sum Invested Regularly {Time Value of Money Tutorial}

How to Calculate the total money in EPF Account

## 12 Comments

nik siong

January 2, 2008the answer is RM 8163.82.

KCLau

January 17, 2008Hi Nik Siong,

You’ve got the right answer!

Congratulations!

mllclim

January 31, 2008$7,000.00 3.2% 01.01.07 $18.6667

$7,018.67 3.2% 01.02.07 $18.7164

$7,037.38 3.2% 01.03.07 $18.7664

$7,056.15 3.2% 01.04.07 $18.8164

$7,074.97 3.2% 01.05.07 $18.8666

$7,093.83 3.2% 01.06.07 $18.9169

$7,112.75 3.2% 01.07.07 $18.9673

$7,131.72 3.2% 01.08.07 $19.0179

$7,150.73 3.2% 01.09.07 $19.0686

$7,169.80 3.2% 01.10.07 $19.1195

$7,188.92 3.2% 01.11.07 $19.1705

$7,208.09 3.2% 01.12.07 $19.2216

$7,227.31 3.2% 01.01.08 $19.2728

$7,246.59 3.2% 01.02.08 $19.3242

$7,265.91 3.2% 01.03.08 $19.3758

$7,285.29 3.2% 01.04.08 $19.4274

$7,304.71 3.2% 01.05.08 $19.4792

$7,324.19 3.2% 01.06.08 $19.5312

$7,343.73 3.2% 01.07.08 $19.5833

$7,363.31 3.2% 01.08.08 $19.6355

$7,382.94 3.2% 01.09.08 $19.6879

$7,402.63 3.2% 01.10.08 $19.7404

$7,422.37 3.2% 01.11.08 $19.7930

$7,442.17 3.2% 01.12.08 $19.8458

$7,462.01 3.0% Yr 2009 $223.8603

$7,685.87 3.0% Yr 2010 $230.5761

$7,916.45 3.0% Yr 2011 $237.4934

$8,153.94 Total

i didnt get the answer right. May i know where did i go wrong? Thank you.

KCLau

February 2, 2008@mllclim,

the last three years should be compounded monthly too, just like what you’ve done for the first 2 years.

kelvin

April 18, 2009Mr KC Lau,

can you show me how to calculate ROI And EAR.

If I purcahse a saving plan for 20 yrs cost me Rm 20,000 and my returned at them is only Rm18,000. what is my ROI and EAR.

what happen if i don’t surrender and 10 yrs later i withdraw and the amount are Rm40,000

what is my ROI and EAR?

please ahow me in detail how to calculate for the above 2 scnerio.

i am very weak in math and hopefully you can show me more in detail.

tks.

meg

December 10, 20093.2% compounded monthly = 3.247% p.a. (using the above formula)

3.0% compounded monthly = 3.0416% p.a.

1st year: 7000*3.247% = 7227.315 (rounding error)

2nd year: 7227.315*3.247% = 7462.011

3rd year: 7462.011*3.0416% = 7688.975

4th year: 7688.975*3.0416% = 7922.843

5th year: 7922.843*3.0416% = 8163.824

Carol

January 19, 2010Hi KC Lau, in your example above, what is the ear per annum for the five-year period and how is it calculated? TIA!

chea F. Kennedy

October 20, 2010Calculating EAR You are looking at an investment that has an effective annual

rate of 16 percent. What is the effective semiannual return? The effective quarterly

return? The effective monthly return?

AnTakTau

May 5, 2012the formula partially correct.

you should include inflation rate. last figure that i known, it stand at 3.0++%.

all in all, your fixed deposit only growing by numbers, not the real value.

Adi

March 21, 2016Mr KC Lau,

can you show me how to calculate this exercise Using annual, semiannual, and quarterly compounding periods for each of the following, (1) calculate the future value if $5,000 is deposited initially, and (2) determine the effective annual rate (EAR).

a. At 12% annual interest for 5 years.

b. At 16% annual interest for 6 years.

c. At 20% annual interest for 10 years.

KCLau

March 21, 2016Hi Adi,

I would like to help you with more explanation. But your question is not structured right, showing that you need more understanding about the issue. For example,

– on question 1: $5000 deposited initially. But you didn’t give a rate of return, say 5% p.a., payable quarterly, monthly or semi-annually will provide different EAR

– on question 2: 12% annual interest for 5 years, the EAR will be 12%, no need calculation at all. Unless it is 12% flat rate, that mean every year return is 12% based on initial deposit say RM5000, not compounded. Then the EAR will be different.

–

[…] Sorry that I don’t want to confuse you with this jargon. In layman terms, just compare the effective annual rate (EAR) of return on where you put the money now. Since the personal loan interest is 5.75%, it is better […]

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