APR or EAR: Some hints for problem-solving

Suppose you have a credit card which charges an interest rate of 1.5% per month. This
would be reported as an 18% annual rate, computed as 1.5% x 12. Yet, if you owed $100
on this account, and did not make any payments for an entire year, the balance at the end
of the year would be $119.56 rather than $118. That higher balance implies 19.56%
interest instead of 18%. It is higher because of monthly compounding, and is computed as
$100 x (1 + .015)12.
To distinguish between these rates, we call 18% the APR, and 19.56% the EAR. This is
described in Section 3.6 in our textbook, and in the end of chapter problems 11 and 12.
So now we have three different interest rates for the credit card: the 1.5% monthly rate,
the 18% APR, and the 19.56% EAR. Which rate should you use for solving a numerical
problem?
If you are using the formulas from the text, do everything in months. Set r = .015 (the
1.5% monthly rate converted to a decimal), and your t should also be expressed in
months (e.g., t = 12 if you want one year).
In contrast, your financial calculator needs the APR, and it wants a percent rather than a
decimal. So for the credit card problem you would enter 18 as the interest rate. You must
also be sure the calculator is using 12 payments per year. (See your calculator manual for
how to set or change the payments per year. Typically it uses a P/YR or P/Y key.) But
even though your calculator wants an annual number for the interest rate, it wants a
monthly number for the payment (with the PMT key) if there are constant payments
made every month.
Now lets turn to bonds with semi-annual interest. A 6-year 10% bond would pay $100
per year in interest (we always assume the face value is $1000), so that is $50 every 6
months. What is this bonds price if its yield to maturity (YTM) is 8%?
The key to solving semi-annual bond problems is to know that YTM is like an APR. We
can follow the procedure described above for the credit card, except now we have 6month periods. The YTM can be viewed as an annual discount rate. If you are using
formulas from the text, we dont want to use an annual discount rate, what we really need
is a 6-month discount rate. Therefore set r = .04 (half of the YTM). The coupon amount
is $50, and t = 12 for the 6-year maturity (because there are 12 6-month periods in the 6
years).
But on your financial calculator, enter 8 as the interest rate for this bond problem. Like
the credit card problem, your calculator wants an annual rate. Because we actually have
semi-annual interest, enter 2 as the number of payments per year. And the PMT is 50, the
amount of each 6-month interest payment. (Like every bond problem, you dont directly
use the coupon rate in your PV calculations; we used the 10% coupon solely to figure out
that the PMT is $50.) You will find that the price of the bond is $1,093.85.

Notice that the calculations described in the previous paragraphs do not use EAR. For
most problems, we dont need the EAR. The general rule is to use the per-period interest
rate (e.g., monthly or semi-annual) for formulas, and use the annual APR on your
financial calculator. And if the payments and compounding are just once a year, then we
dont have to worry about any of this because all the interest rates (EAR, APR, r, and the
interest rate for your financial calculator) are the same when there are annual periods.
Finally, consider Canadian mortgages. In 3530 we will always follow the approach
described in example 3.19 on pages 97-98. In Canada, mortgage rates are quoted with
semi-annual compounding, but this is deceptive because the mortgage payments are
monthly. So we must convert the posted rate. If you want to use formulas, get the
monthly rate like 0.006356 shown in the last line of p. 97. If you want to use your
financial calculator, multiply your monthly rate by 12 to get the true APR. From the
bottom of p. 97 and not rounding off the monthly rate, take 12 x 0.00635646163 =
0.07627753956. You can then enter that annual rate on your financial calculator, along
with 12 payments per year.