Universal Bank pays 7.3%, compounded annually, on time deposits. Regional Bank p

Question

Universal Bank pays 7.3%, compounded annually, on time deposits. Regional Bank pays 7% interest, compounded monthly.

1) Based on effective interest rates, in which bank which you prefer to deposit your money?

2) Would your choice of banks be influenced by the fact that you might want to withdrawyour 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 an entire compounding period in order for you to receive any interest.

Explanation / Answer

1)

Universal bank EAR = 7.3%

Regional bank EAR = (1+7%÷12)^12-1 = 7.22%

I will prefer universal bank, as it has higher EAR.

2)

In this case, I will prefer regional bank as it enables the depositor to receive the interest monthly rather than annually.

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