APY vs APR: Key Differences in the Financial World

In the field of decentralized finance (DeFi), it is common to encounter the terms APY and APR. Although they seem similar, there are significant differences between them that every investor should understand.

Understanding APR and APY

The Annual Percentage Rate (APR) is a relatively simple concept. It represents the simple interest earned or paid on a capital over a year, without taking into account capitalization.

For example, if you invest 10,000 dollars in an account with an APR of 20%, at the end of the year you will have earned 2,000 dollars in interest. Your total balance would be 12,000 dollars. After two years, you would have 14,000 dollars, and so on.

The Annual Percentage Yield (APY), on the other hand, takes into account the effect of compound interest. This means you earn interest not only on your initial capital but also on previously accumulated interest.

Using the same example, if that $10,000 is invested in an account with a 20% APR compounded monthly, at the end of the year you would have approximately $12,429. The compound interest has generated you an additional $429.

The power of compound interest

The capitalization frequency plays a crucial role in the APY. The more frequent the capitalization, the higher the final yield.

If we take the previous example but with daily compounding, the final balance would be around $12,452. Extending the period to three years, with the same rate and daily compounding, the amount would rise to about $19,309.

This multiplier effect of compound interest is what generally makes the APY more attractive for long-term investors.

Comparing interest rates

When evaluating different financial products, it is crucial to compare using the same metric. A product with a higher APY does not necessarily generate more interest than one with a lower APR, depending on the compounding frequency.

In the DeFi ecosystem, make sure to convert the rates to the same base ( whether it's APY or APR) before comparing. Also, check the compounding frequency, as two products with the same APR may generate different returns if compounded at different frequencies.

Precautions in the crypto world

In the realm of cryptocurrencies, it is essential to understand what APY truly means in each specific product. Some may use the term to refer to cryptocurrency rewards over a certain period, rather than an actual yield in fiat currency.

Remember that the prices of digital assets are volatile. Even with an attractive APY, the value of your investment in fiat currency could decrease if the price of the asset falls significantly.

Conclusion

Although APR and APY may seem confusing at first, the key is to remember that APY takes compound interest into account, making it more complex but potentially more beneficial for the investor.

Due to the effect of compound interest, when the compounding frequency is greater than once a year, the APY will always be higher than the APR. When calculating your potential earnings, make sure you are using the correct interest rate and considering all relevant factors.

Warning: This article is for informational and educational purposes only. It does not constitute financial advice nor does it recommend the purchase of specific products or services. The prices of digital assets are highly volatile. Your capital may be at risk, and it is your responsibility to make informed investment decisions. Gate is not responsible for potential losses. Please review the terms of use and risk warnings before investing.