Even though it may be stated that you have a given APR (Annual Percentage Rate), on your account (savings, credit card, etc) the EAR (Effective Annual Rate) may be much higher. Today, I am going to show you how to actually figure out the rate that you are getting (or paying).

The secret lies in the frequency of the interest compounding. The more often the balance compounds, the faster the money grows (we all know this) and the higher the effective interest rate. Some calculators make the conversion process quite simple (if you know what buttons to push) but I am going to explain how to calculate this amount without using a calculator.

The formula itself is quite simple. Take the stated interest rate (APR) as a decimal divided by the number of times it compounds in a year (12 for monthly, 365 for daily, etc) and add 1. Then, square that result (take it times itself) and finally, subtract 1. The result will be the effective rate as a decimal.

This effective rate can than be compared with the effective rates of your other options when trying to decide which option to take when saving or borrowing money. This is especially useful when the different options compound at different intervals.

What we see is that if you are saving money, look for the opportunity that offers not only the best interest rate, but also compounds the most often. When you are borrowing money, look for not only the lowest possible interest rate, but also the option that compounds the least number of times per year.

In some cases, you may be better off choosing a higher interest rate that compounds less often when borrowing money and when saving you may be better off choosing a lower interest rate that compounds more often. It’s not just the APR that you need to look at, it’s the EAR as well.