What effect does compounding interest more frequently

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Question: What effect does compounding interest more frequently than annually have on its future value and the effective annual rate (EAR)? Explain. How would you explain the difference between the annual percentage rate (APR) and effective annual rate (EAR) to a friend with no background in finance?

The effect of compounding interest more frequently than annually will definitely have an impact on its future value as well as the effective annual rate (EAR). First of Compound interest is interest paid on an investment's original principal and on interest accumulated over previous periods. Savings institutions compound interest semiannually, quarterly, monthly, weekly, daily, or even continuously. "The more often interest compounds, the larger the future amount that will be accumulated, and the higher the effective, or true, annual rate (EAR)." (Smart & Zutter, 2019). This is because the future value of a dollar is typically less than the current value, therefore compound interest can reverse the historical devaluation of each dollar. Actually, increasing inflation can drive the future value of money down faster than time alone. Compound interest rarely compensates for the typical decline in the value of money in the short term, on the other hand, it can counteract that decline over more extended periods. If I had to explain the difference between the annual percentage rate (APR) and the effective rate (EAR), I would start by defining each. APR is an annual percentage rate charged on the mortgage, credit card, etc., or earned on an investment. It is an annual cost of borrowing the funds. EAR is a compound interest rate that is charged on borrowing funds or earned on an investment. It is higher than (APR). It is an amount that you actually pay or receive. So basically, (EAR) is a rate that you really pay or receive while APR is the cost of borrowing the amount.

Reference no: EM133388841

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