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Compounding period and effective interest rate

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Universal Bank pays 7 percent interest, compounded annually, on time deposits. Regional Bank pays 6 percent interest, compounded quarterly.

a. Based on effective interest rates, in which bank would you prefer to deposit your money? Why
b. Could your choice of banks be influenced by the fact that you might want to withdraw your funds during the year as opposed to at the end of the year? In answering this question, assume that funds must be left on deposit during the entire compounding period in order for you to receive interest.

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Solution Preview

a. Based on effective interest rates, in which bank would you prefer to deposit your money? Why
Universal bank's effective interest rate = 7%
Regional bank's effective interest rate = ...

Solution Summary

The problem explains the how the compounding frequency and compounding periods play a role in the effective interest rate realized by the investors. It also discusses whether it is better for the investor to invest in higher compounding frequency when the effective interest rates realized are different.

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