How is the effective annualised return (EAR) calculated
What is EAR?
The Effective Annualised Return (EAR) calculation is also known as effective annual interest rate method and is used as a consistent measure of comparing different interest rates.
EAR includes the effects of intra-year compounding and is the annualised return on an investment restated from its nominal interest rate. It assumes that principal and interest payments are immediately reinvested and therefore the interest rate is compounded and payable in arrears.
Clearmatch Funding’s EAR calculation reflects only actual cash payments received and does not incorporate future looking projections of performance. As EAR is traditionally used to compare the annual interest rates between investments with different compounding terms during the year, Clearmatch Funding believes it can provide investors with a more accurate way of calculating total investment returns as opposed to considering only the stated interest rate on an investment.
How is the EAR calculated?
EAR is the output of a formula where the numerator is composed of interest received net of any write-offs. If an investment does not get paid, the interest received for that period will be zero. If an investment is "written-off", the entire outstanding balance of the investment is subtracted from the numerator. Thus, in the numerator, we accumulate all interest received minus any write-offs for all relevant periods.
Next, we divide this result by the denominator, which is the accumulation of the outstanding principal amount of an investment for all relevant periods. This yields a fraction for the period.
The final step in the calculation involves annualising the result. We take 1 + the dollar-weighted average performance for all periods, raise it to the 12th power to reflect the number of compounding periods for the year, and subtract 1. This result is the Effective Annualised Return, expressed as a percentage.
See formula below:
Formula Rules
The following are rules and examples when calculating the EAR:
1. Determining when investments can be included in the formula
- To be included in the EAR calculation, an investment must have been issued more than three (3) months prior to the calculation date.
2. Determining which periods are included in the formula
If it’s been more than 3 months since investment purchase, an EAR can be calculated . After that, the EAR calculation is perpetual (until termination of the loan): meaning, loans don’t drop out after 12 months of history. This is why the formula is annualised and results in a fair assessment of determining an investor’s investment performance.
3. How do we calculate the outstanding principal amount of an investment for a particular period
The outstanding principal amount for an investment for a particular period is based on the weighted average of the principal balance that was outstanding for the period (a month or partial month). Example on January 1 2013 the principal on an investment was $2,000. On the 5th of the month, a payment was made and applied resulting in $200 reduction in principal. On the 20th of the month, another payment was made and applied resulting in $200 reduction in principal. Based on the table below, the outstanding principal balance for this investment is $1,748.39
Start Date | End Date | Principal outstanding | # of days | Principal Amount |
Jan 01 | Jan 04 | 2000 | 4 | 258.06 |
Jan 05 | Jan 19 | 1800 | 15 | 870.97 |
Jan 20 | Jan 31 | 1600 | 12 | 619.35 |
31 | 1748.39 |
4. Limitations of EAR
EAR is just one method to calculate the return on cash invested. We think it is the most useful and accurate way to measure investment performance and compare effective returns because it takes into account actual cash received and write-offs.
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