What is the Annual Equivalent Rate (AER)?
Same as the effective annual interest rate, the annual equivalent () rate is the rate of interest an investor earns in a year after for the effects of . The formula for is:
(1 + i/n)n - 1
i = the stated annual interest rate
n = the number ofperiods in one year
How Does the Annual Equivalent Rate (AER) Work?
For example, let’s assume you buy a certificate deposit with a 12% stated annual interest rate. If the bank compounds the interest every month (that is, 12 times per year), then using this information and the formula above, the on the CD is:
(1 + .12/12)12 - 1 = .12683 or 12.683%
Let’s look at it from another angle. Assume you put $1,000 into the 12% CD. Over 12 months, the investment will look like this:
The percentage change from $1,000 to $1,126.83 is ($1,126.83 - $1,000)/$1,000 = .12683 or 12.683%. Even though the bank has advertised a 12% interest rate, your money actually grew by 12.683%.