How do you calculate the effective annual rate (EAR)?

To determine the effective annual rate (EAR), the correct formula is derived from compounding the nominal interest rate over a year. The formulation of EAR as (1 + (nominal rate / n))^n - 1 accounts for the number of compounding periods (n) within the year, allowing for the true annual interest to be calculated.

Using this formula, if you divide the nominal interest rate by the number of compounding periods (n), you get the interest applied per period. When that value is added to one and raised to the power of the number of periods (n), it effectively accounts for the interest being compounded multiple times throughout the year. Finally, subtracting one gives you the actual growth of your investment or loan over the year, expressed as a percentage.

This formulation is crucial because it reflects the impact of compounding, which can significantly affect the total interest earned or paid over time. Therefore, option B correctly encapsulates the method to calculate the EAR, emphasizing the essential concept of compounding in understanding interest rates and personal finance.