how to calculate the aer
to calculate aer the aer is displayed as a percentage example of aerlet s look at aer in both savings accounts and bonds assume an investor wishes to sell all the securities in their investment portfolio and place all the proceeds in a savings account the investor is deciding between placing the proceeds in bank a bank b or bank c depending on the highest rate offered bank a has a quoted interest rate of 3 7 that pays interest on an annual basis bank b has a quoted interest rate of 3 65 that pays interest quarterly and bank c has a quoted interest rate of 3 7 that pays interest semi annually the stated interest rate paid on an account offering monthly interest may be lower than the rate on an account offering only one interest payment per year however when interest is compounded the former account may offer higher returns than the latter account for example an account offering a rate of 6 25 paid annually may look more attractive than an account paying 6 12 with monthly interest payments however the aer on the monthly account is 6 30 as opposed to an aer of 6 25 on the account with annual interest payments therefore bank a would have an annual equivalent rate of 3 7 or 1 0 037 1 1 1 bank b has an aer of 3 65 1 0 0365 4 4 1 which is equivalent to that of bank a even though bank b is compounded quarterly it would thus make no difference to the investor if they placed their cash in bank a or bank b on the other hand bank c has the same interest rate as bank a but bank c pays interest semi annually consequently bank c has an aer of 3 73 which is more attractive than the other two banks aer the calculation is 1 0 037 2 2 1 3 73 let s now consider a bond issued by general electric in march 2019 general electric offered a noncallable semiannual coupon with a 4 coupon rate expiring dec 15 2023 the nominal or stated rate of the bond is 8 or the 4 coupon rate times two annual coupons however the annual equivalent rate is higher given the fact that interest is paid twice a year the aer of the bond is calculated as 1 0 08 2 2 1 8 16 annual equivalent rate vs stated interestwhile the stated interest rate doesn t account for compounding the aer does the stated rate will generally be lower than aer if there s more than one compounding period aer is used to determine which banks offer better rates and which investments might be attractive advantages and disadvantages of the aerthe primary advantage of aer is that it is the real rate of interest because it accounts for the effects of compounding in addition it is an important tool for investors because it helps them evaluate bonds loans or accounts to understand their real return on investment roi unfortunately when investors are evaluating different investment options the aer is usually not stated investors must do the work of calculating the figure themselves it s also important to keep in mind that aer doesn t include any fees that might be tied to purchasing or selling the investment also compounding itself has limitations with the maximum possible rate being continuous compounding unlike the apr aer reveals the actual interest rate crucial in finding the true roi from interest bearing assets investors must do the work of calculating aer themselves aer doesn t take into account fees that may be incurred from the investment compounding has limitations with the maximum possible rate being continuous compounding special considerationsaer is one of the various ways to calculate interest on interest which is called compounding compounding refers to earning or paying interest on previous interest which is added to the principal sum of a deposit or loan compounding allows investors to boost their returns because they can accrue additional profit based on the interest they ve already earned one of warren buffett s famous quotes is my wealth has come from a combination of living in america some lucky genes and compound interest 1 albert einstein reportedly referred to compound interest as mankind s greatest invention 2