Understanding APR and EAR in Loans and Investments
Which one of the following statements is correct?
Multiple Choice
a) The EAR is always greater than the APR.
b) The APR is the best measure of the actual rate you are paying on a loan.
c) The APR on a monthly loan is equal to (1+ monthly interest rate ) 12−1.
d) The EAR, rather than the APR, should be used to compare both investment and loan options.
e) The APR is equal to the EAR for a loan that charges interest monthly.
Final answer:
The correct answer is d) The EAR should be used to compare both investment and loan options as it accounts for the effects of compounding. For adjustable-rate mortgages, a drop in inflation likely means lower interest rates and monthly payments. ARMs often start with lower interest rates as they adjust with inflation, offering a different risk profile compared to fixed-rate loans.
Explanation:
The correct statement from the given options is d) The EAR, rather than the APR, should be used to compare both investment and loan options. The Effective Annual Rate (EAR) takes into account the effects of compounding within the year, making it a better measure of the true cost of borrowing or the true yield on an investment than the Annual Percentage Rate (APR), which does not consider the compounding within the year.
Regarding adjustable-rate mortgages (ARMs), if inflation falls unexpectedly, market interest rates typically decrease as well. For a homeowner with an ARM, a decrease in inflation would likely lead to lower interest rates for their mortgage, resulting in lower monthly payments.
An ARM generally offers lower initial interest rates compared to a fixed-rate loan because the lender is protected from the risk that higher inflation will diminish the real value of the loan payments. This means that with an ARM, the interest rate can adjust upward or downward with inflation, representing a different risk profile compared to fixed-rate loans which have static interest rates throughout the life of the loan.