To earn the highest effective interest rate, which compounding frequency should be chosen?

To earn the highest effective interest rate, which compounding frequency should be chosen?

• A. Daily
• B. Monthly
• C. Annually
• D. Quarterly

Answer: (A)

More frequent compounding yields a higher effective interest rate when the nominal rate is the same. The effective annual rate (EAR) reflects not just the stated rate but how often interest is added to the balance: EAR = (1 + i/m)^m − 1, where i is the nominal annual rate and m is the number of compounding periods per year. As m increases, (1 + i/m)^m grows, so the EAR rises. Among the options, daily compounding uses the largest number of periods per year (about 365), so it gives the highest EAR. Monthly, quarterly, and annual compounding add interest less frequently, resulting in lower effective rates.

More frequent compounding yields a higher effective interest rate when the nominal rate is the same. The effective annual rate (EAR) reflects not just the stated rate but how often interest is added to the balance: EAR = (1 + i/m)^m − 1, where i is the nominal annual rate and m is the number of compounding periods per year. As m increases, (1 + i/m)^m grows, so the EAR rises. Among the options, daily compounding uses the largest number of periods per year (about 365), so it gives the highest EAR. Monthly, quarterly, and annual compounding add interest less frequently, resulting in lower effective rates.