Final answer:
The effective annual rate (EAR) considers the effect of compounding, while the annual percentage rate (APR) does not. EAR is the actual interest rate earned or paid over a year, taking into account compounding periods. APR is the nominal interest rate that does not consider compounding.
Step-by-step explanation:
The effective annual rate (EAR) takes into account the effect of compounding, while the annual percentage rate (APR) does not consider compounding. The EAR is the actual interest rate earned or paid over a year, taking into account the compounding periods within that year.
On the other hand, the APR is the nominal interest rate that does not consider compounding. It is calculated by multiplying the periodic interest rate by the number of periods in a year, usually 12 for monthly compounding.
For example, let's say you have a loan with an APR of 6% and monthly compounding. The monthly interest rate would be 6% divided by 12, which is 0.5%. However, the effective annual rate will be slightly higher due to the compounding effect. It can be calculated using the formula: (1 + r/n)^n - 1, where r is the nominal interest rate and n is the number of compounding periods in a year.
Using the formula, the effective annual rate for the loan with an APR of 6% would be (1 + 0.005)^12 - 1 = 6.16778%. So, the EAR takes into account the compounding effect and gives a more accurate measure of the true interest rate.