Answer to Question #130416 in Finance for smegnew

Question

What effect does compounding interest more frequently than annually have on (a) Future value and (b) The effective annual rate (EAR)? Why?

Answer 1

$$Solution$$

a)The more compounding periods in a given year, the stronger the affect on future investment value. Therefore the more interest-posting dates, the more compounding increases the account balance, regardless of the interest rate.

b)  Effective annual interest rate (EAR) is an annual interest rate when compounding period differs from one year. In other words, effective interest rate is the actual interest when interest is compounded more than once a year. In this case, interest is compounded on both the principal (initial investment) and the interest that has already accrued. As the number of compounding periods increases, so does the effective annual interest rate.