Annual equivalent rate definition
Annual equivalent rate shows the rate which will be paid on savings and investments after adjustments for the effects of compounding interest are made. AER is expressed in percentage and is used for calculating true earnings. It has particular application when the interest rate is expressed over a shorter period than a year, i.e., the interest is paid more often. For instance, AER can be useful when estimating the earnings from saving accounts where interest is paid monthly or quarterly.
What is annual equivalent rate?
Financial institutions offer a variety of savings accounts and instruments for potential savers. In order to attract clients to deposit their money with them, institutions pay interest. The interest rate paid on saving products, such as time deposits, is the return the saver will earn. This interest rate is referred to as gross interest rate.
A financial institution can offer saving products with different characteristics. These products could differ on the basis of the maturity period, payment period, minimum limit amount, frequency of interest payments, etc. One of the main characteristics which should be taken into account is the frequency of interest payments. The frequency means how many times per year the saver will receive interest. In the case of a one-year term deposit with interest paid at the end of the year, the saver will receive one interest payment.
However, some saving products pay interest multiple times per year; every month, quarterly, or semi-annually. With this type of interest payments, the quoted interest rate does not represent the real return. Because there are multiple periods when interest is paid, the interest rate does not take into consideration the effect of reinvesting the interest earned. The reinvestment of interest received in each period offers the potential for additional earnings. This is known as a compounding interest or an interest earned on reinvested interest.
Because of the potential for the saver to earn additional income by reinvesting the interest received, the annual equivalent rate represents the true return of a saving product. The AER will be higher than the gross interest rate. For this reason, when a comparison is made, AER should be considered since it shows the full return an investor will make. Let’s say that a saving product pays interest four times per year. AER assumes that the first interest received will be reinvested; the second interest will be reinvested as well, and so on. Reinvesting the interest amount received then generates additional income.
A deposit with a lower gross interest rate paid more frequently could provide a higher return than a deposit with a slightly higher interest rate paid annually. AER should be used when looking for a deposit which will generate the highest earnings because it shows how much money the deposit or savings can generate in one year.
Difference between AER and APR
Annual percentage rate (APR) represents the full cost of a loan when all loan related costs and fees are taken into consideration. On the other hand, AER shows the true interest rate a saver will receive on a deposit. Therefore, AER provides insight into the full earning potential for a saver when opening a savings account.