The Concept of Effective Interest Rate and The Main Differences Between APR and EAR

Time Value of Money
Your Name
Department, University
Subject and Section
Professor’s Name
Date
* What effect does compounding interest more frequently than annually have on (a) the future value, and (b) the effective annual rate (EAR)? Explain.
Understanding the mechanisms of compounding is essential for any investor. It allows him to make better and more strategic decisions about allocating his resources, thereby maximizing returns and minimizing risk. One of the essential principles that every investor should know is the concept of effective interest rate (EIR). Simply said, this principle refers to the actual interest received by a loan when the interest compounds more than once per annum. One of the reasons this is highly advantageous is the compounding effect. Specifically, the interest is computed from the actual principal investment and the accrued and accumulated interest. In other words, this leads to exponential growth.
Nonetheless, EIR is different from other interests because of the recurrence of the compounding process. In ...