What happens to the EAR as the number of compounding periods increases?

The effective annual rate (EAR) reflects the actual return on an investment when compounding occurs more frequently than once per year. When the number of compounding periods increases, the effects of compounding become more pronounced. This means that interest is being calculated and added to the principal amount more frequently, allowing the investment to grow at an accelerated rate.

As the compounding periods increase—such as moving from annual to semi-annual to quarterly and then monthly—each period's interest is calculated not just on the original principal but also on the interest that has already been added to it. This results in a higher effective annual rate. Therefore, with an increase in the number of compounding periods, the EAR also increases, demonstrating the benefits of more frequent compounding on investment growth.

In contrast, if the number of compounding periods remains the same, decreases, or becomes non-applicable, the principles of compounding would not apply in the same way, and the effective annual rate would either not change or would not reflect the maximum potential growth of an investment from compounding interest.