APY vs APR: What's the Difference?Nov 2, 2022
Investment terminology can often cause confusion even to a knowledgeable crypto investor. Today we'll talk about the very basics of APY and APR and how it relates to DeFi cryptocurrency products.
- APR vs. APY breakdown
- APR and APY calculation formulas
- What is the difference between APR and APY and why is it important to know
APR vs APY: Basics of Interest Calculation
When talking about DeFi tools such as staking, saving, yield farming, and lending, APR and APY terminology is of vital importance to be grasped. Like for any financial product, the interest on decentralized finance products is calculated using annual percentage rates (APR) and annual percentage yield (APY). Sounds pretty similar, but there's one substantial difference between these two.
|Source: Arctic Wallet
What is APR in crypto?
APR, Annual Percentage Rate, is a percentage of interest an investor or depositor earns over a year on an initial cryptocurrency investment. APR is a simple and straightforward rate calculated directly from the amount invested.
Investing 10,000 coins at 10% APR will result in 11,000 coins by the end of one year
|Calculating APR vs. APY
Useful Tip: counting crypto interest rates in fiat (i.e. dollars) may be giving misleading outcomes as cryptocurrencies are known to be highly volatile.
APY: The big difference is compounding
APY, or Annual Percentage Yield, takes compound interest rates into consideration. Compounding means earned interests get added to the original amount invested and generate rewards on top of the initial investment.
Since APY is applying interest to all previously interest accumulated as well (instead of applying it solely to initial investment like APR), it provides higher total profit.
How to Calculate APY?
The general APY formula (if applied for 1 year) is the following:
APY = (1 + interest rate for a year / compounding frequency) compounding frequency - 1
Useful Tip: to facilitate calculations, you may want to use one of many online APY calculators that make investor's life much easier and count it for you in a few clicks.
As seen from the table above, 10k coins invested, at a 10% rate with daily compounding counted in, leave us at 11,051 coins in total and 1,051 coins earned (if we remain invested for a year).
Why it's important to understand APR and APY?
The two terms often get misinterpreted. Understanding the differences between APY and APR is essential when considering financial products from different DeFi protocols.
Some DeFi tools use the APR system, so if you want to get higher returns you may manually reinvest payouts if the service allows doing so. An automatic compounding mechanism is also a thing and comes in handy for effortless passive income generation.
APR vs APY: Insights
1. APY is generally more profitable than APR as it gives you rewards on top of rewards, while APR gives the same return from year to year.
2. The higher the rate, the higher the difference between APR and APY will be.
3. APY depends on how often it's compounded: the higher the frequency = the higher the yield. Similarly, the longer you stay invested, the more effect compounding will have.
4. Do your own research (DYOR) carefully when a certain protocol pledges thousands of percent of APY, as sometimes the rate is designed to float over the period depending on the market.
Plus, liquidity pools frequently offer tempting 100+% APYs to attract investors, when in fact, the liquidity provider's yield is calculated proportionally to the number of total providers and ends up being much less than promised.
5. The rate that you look at should be linked to your preferred time frame as not everybody is willing to stay invested for a whole year. In this case, comparing daily rewards from different protocols gives a clearer picture.
The Bottom Line
Hopefully, today's post cleared up the differences between APR and APY. One important takeout is that APY is considered to be more profitable in comparison to APR. Yet, different financial products may offer different conditions for their services. Therefore, it is important to research in detail how annual percentage rates and annual percentage yield apply to specific offers.