Unit 5: Basic Long-Term Financial Concepts

5.2. Effective Annual Interest Rate

Questions to Ponder
1. Why do some Filipinos resort to illegal sources when borrowing funds?
Answers may vary. Some Filipinos lack in financial literacy and the only available nearer
and easier to avail is the “5-6” schemes of money lending.

2. Is it better to have credit cards in case of emergencies?

Answers may vary. It depends on the credit card holder. If the holder does not have a
stable job to pay the debts it is not wise to use credit cards. Some situations that if you
lack cash in hand, credit cards are the best way to use.

3. What do you think is the proper use of credit cards?

Answers may vary. Being responsible and keen in spending money. Impulsive buying
and prioritizing the wants should be avoided especially if using credit cards.

Check Your Progress

1. If investment A has an annual interest of 5% compounded monthly and investment
B has an annual interest of 5% compounded semi-annually, which investment is
better?
Investment A: EAR = 5.12%, Investment B: EAR = 5.06%. Since this is investment, the
company that offers a bigger interest rate is a better deal. Hence, investment A.

2. If you are an investor, would you prefer an investment with interest that has more
compounding periods or those with less (provided that the stated interest are the
same)? Explain your answer.
If I am an investor, I would go for securities with interest rates that compound more
frequently because it will yield higher effective annual return.

5.2. Effective Annual Interest Rate 1

 Unit 5: Basic Long-Term Financial Concepts
Try This

A. Identification. Write the correct answer on the provided space before each number.

Effective 1. It is used to determine the exact rate of return in an investment

annual interest or interest charged in a loan.
rate

Nominal rate or 2. An interest that does not take compounding periods into
APR account.

12 3. The number of periods when compounded monthly.

Investment or 4. A higher EAR is preferable in this activity.

investing

Borrowing 5. A lower EAR is preferable in this activity.

funds

B. True or False. Write true if the statement is correct. Otherwise, write false.

True 1. EAR is always higher than APR unless the interest is only
compounded annually.

True 2. More often compounding periods mean higher interest.

False 3. EAR can only be used for investing purposes only.

True 4. Banks and other financial institutions use APR to lure

customers.

True 5. EAR includes compounding periods into account.

5.2. Effective Annual Interest Rate 2

 Unit 5: Basic Long-Term Financial Concepts
Practice Your Skills
1. An investor gathered information regarding each company's interest rate return. He
asked for your help to determine which company has a bigger return on investment.
Complete the table by supplying the effective annual interest rate in each column.

Effective Annual
Company Annual Interest Rate
Rate

Company A 17% compounded semi-annually 17.72%

Company B 17% compounded annually 17.00%

Company C 17% compounded quarterly 18.11%

Company D 17% compounded monthly 18.39%

2. In which company should the investor invest his money? Explain your answer.
The investor should invest his money in Company D. With the use of an effective annual
interest rate formula, we were able to determine the actual interest rate return of the
investment. Company D has the highest actual return compared to the other companies.

3. A businessman would like to get a loan from a bank to renovate his store. He
gathered information regarding each bank's interest rate. Help the businessman
decide in which bank he should get his loan. Complete the table by supplying the
effective annual interest rate in each column.

Effective
Company Annual Interest Rate
Annual Rate

Bank A 5% compounded quarterly 5.09%

Bank B 5% compounded monthly 5.12%

Bank C 5% compounded semi-annually 5.06%

Bank D 5% compounded annually 5.00%

4. In which bank should the businessman get his loan? Explain your answer.
The businessman should get his loan from Bank D. Bank D has the lowest effective rate
which means it offers a lower interest rate compared to other banks.

5.2. Effective Annual Interest Rate 3

 Unit 5: Basic Long-Term Financial Concepts
5. Why each bank do not use the EAR instead of the APR?
The banks will not advertise 5.06% of interest rate but rather they will prefer to advertise
a 5% interest rate. They want the clients to think that they are paying less than the other
banks. They offer which looks more favorable in the eyes of the individuals.

Challenge Yourself
1. Company A charges 12% interest on loans compounded semi-annually, and
Company B charges 12% interest on loans compounded monthly. Which company
has a better deal? Explain your answer.
Company A with an EAR of 12.36%. Since it is a loan company, lower EAR is a better deal.

2. A businessman decided to invest his money in a company. Company X offers 15%

interest compounded monthly, while Company Y offers 15% compounded quarterly.
In which company should the businessman invest his money? Explain your answer.
Company X with an EAR of 16.08%. Since it is an investment company, higher EAR is a
better investment.

3. Provide a scenario wherein failure to compute the Effective Annual Interest can
cause drastic effects on a business’s performance. Explain your answer.
Answers may vary. A business that makes a loan without computing for the effective
annual interest can experience difficulties in paying off its debt. It may have drastic
effects on its cash flow and liquidity, which are important aspects in business operations
and performance.

5.2. Effective Annual Interest Rate 4