The annual equivalent rate is the rate at which interest would be paid on an investment over the course of a year. The rate is a good opportunity to compare returns or interest on investment, and also to get a more accurate prediction as to what that investment will actually earn. The reason why the annual equivalent rate is different than the annual percentage rate is because interest earned and paid during previous points of the year continues to earn interest along with the original principal. In some countries, such as the United Kingdom, the equivalent rate is published as a regular course of doing business for some investment products.
One of the most common situations in which an annual equivalent rate may be used is in bank savings products, such as savings accounts and even certificates of deposit. If a bank is offering six percent interest on an investment product, paid semi-annually, and an investor puts in $100,000 US Dollars (USD), at the midyear point, the total amount will be worth $103,000 USD. At the end of the year, the amount would increase to $106,090 USD. That makes the annual equivalent rate 6.09 percent.
If the interest would have been paid all at once, at the end of the 12-month period, rather than having a payment made halfway through, to get the same amount of money the annual percentage rate would have needed to be set at 6.09 percent. Therefore, the annual equivalent rate is always even with, or more than, the annual percentage rate. When interest is only paid once a year both the rates will be the same.
It is also possible that interest rates are paid more than twice a year. Depending on the investment product, investors may receive interest payments as often as once per month. The increase in the frequency of interest payments would also lead to an increase in the annual equivalent rate. Therefore, not only is the actual percentage rate a big factor in the equivalent rate, frequency of payment can also make a big impact.
To determine the annual equivalent rate, an investor needs to know both the annual percentage rate and frequency of payment. Divide the frequency of payment by the interest rate, and then add one. Next, use the frequency of payment to exponentially increase that sum. For example, if the frequency of payment was twice a year, you would increase the sum to the second power. Once you have that number, subtract one to get the annual equivalent rate.