Bank A pays 4% interest compounded annually on deposits, while Bank B pays 3.5%

Question

Bank A pays 4% interest compounded annually on deposits, while Bank B pays 3.5% compounded daily.

A) Based on theEAR(or EEF%),which bank should you use?

B) Could your choice of banks be influenced by the fact you might want to withdraw your funds during the year as opposed to at the end of the year? Assume that your funds must be left on deposit during an entire compounding period in order to receive any interest.

I know the calculations are correct, but should Bank A be used because its EAR is higher and can you answer question B.

EAR = (1 + i / m)m -1

EAR = (1 + 0.04 / 1)1 - 1 => 0.04 x 100 = 4% for Bank A

EAR = (1 + 0.035 / 365)365 - 1 => 0.035618 x 100 = 3.5618% for Bank B

Explanation / Answer

A) Based on EAR, Bank A should be used.

B) Yes. If funds may have to be withdrawn during the year with the added assumption that Banks pay interest only if the deposit is held during the entire period, then Bank B should be chosen.

If Bank B is chosen the compounding period is a day, because of which it does not matter when the deposit is withdrawn. One will get interest upto the day of withdrawal that too compouded daily.

In the cas of Bank A, if the amount is withdrawn before the end of the year no interest would be paid for the year.

Hence, Bank B is the safest option, though EAR is lower.

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