Lesson 1: Annual Percentage Rate vs Annual Effective Rate - Can you differentiate?

Statement of the Day : Understand that banks are sneaky

When a product provider quotes an interest rate, it is not always immediately apparent how much you will be paying - or be paid - if you take out the product.

Einstein said it best - 'if you can't explain it simply, you don't understand it well enough'.

Finance firms love selling complex products. That way customers don't know what they're buying, won't understand the potential downside risks, or realise the true costs, many of which will be expertly hidden in the small print.

Bank profits are big because as Andrew Ellson, Personal Finance Editor of The Times, perfectly sums up:

 "All Banks employ every trick in the book to disguise the true cost of almost every financial product they sell"

Let's get to this 2 terms before I illustrate examples in my subsequent posts.

Annual Percentage Rate (APR) 

• Also known as nominal rate or simple interest rate per annum
• Does not take into account the effect of intra-year compounding

• Quoted by financial institution when they lend out money, hence earning interest from customers.
• Primary reason being to give customers the impression it costs less to borrow
• Normally applicable to loans, mortgages and credit cards
• APR is always effectively lower than the quoted AER
• APR to AER conversion mathematical equation: AER = (1+APR/n)^n - 1

Annual Effective Rate (AER)

• Also know as Effective Annual Rate (EAR), Annual Percentage Yield (APY) per annum
• Takes into account the effect of intra-year compounding
• Quoted by financial institution when customers deposits money, hence paying interest to customers.
• Primary reason being to give customers the impression customer deposits earns more interests
• Normally applicable to savings accounts, fixed deposits.
• AER is always higher than quoted APR if there is 2 or more intra-year compounding. The only time when AER=APR is when there is no intra-year compounding,
• AER to APR conversion mathematical equation : APR = n*[(AER+1)^(1/n) - 1], where n = number of times for intra-year compounding