Understanding the Difference Between APY and APR

When exploring decentralized finance (DeFi) products, you may have encountered the terms APY and APR. While these two acronyms sound similar, they actually represent different concepts.

Annual Percentage Yield (APY) incorporates quarterly, monthly, weekly, or daily compounding, whereas Annual Percentage Rate (APR) does not take compounding into account. This seemingly simple distinction can significantly impact earnings calculations over time. Therefore, it's crucial to grasp how these two metrics are calculated and how they affect the returns you receive on your digital assets.

APR and APY Explained

Both APR and APY are fundamental to personal finance. Let's start by introducing the relatively straightforward concept of Annual Percentage Rate (APR). APR represents the interest rate a lender earns on their funds over a one-year period, or the interest rate a borrower pays for using those funds over the same timeframe.

For instance, if you deposit $10,000 into a savings account with a 20% annual interest rate, you would earn $2,000 in interest after one year. The interest is calculated as: principal ($10,000) multiplied by the APR (20%). Thus, after one year, your principal plus interest would amount to $12,000. After two years, it would be $14,000, and after three years, $16,000, and so on.

Before delving into Annual Percentage Yield (APY), it's essential to understand compound interest. In essence, compound interest refers to earning interest on previously accrued interest. In the example above, if the financial institution paid interest on your account monthly, your account balance would change each month throughout the year.

Instead of receiving a lump sum of $12,000 at the end of the 12th month, you would receive some interest each month. This monthly interest is added to your deposit principal, so the total amount of money earning interest increases monthly. In other words, the principal you use to earn interest grows month by month. This effect is called compound interest.

Consider depositing $10,000 into a bank account with a 20% APR, compounded monthly. Without delving into complex mathematics, you would have $12,429 after one year. This means the compounding effect can help you earn an additional $429 in interest. Now, imagine depositing $10,000 into a bank account at the same 20% APR, but with interest compounded daily. In this scenario, you would have $12,452 after one year.

The longer the interest period, the more striking the power of compound interest becomes. Suppose you also deposit $10,000 in a bank account with a 20% annual interest rate, compounded daily, but extend the interest accrual period from one year to three years - you would end up with $19,309. Compared to the 20% APR product that doesn't consider compound interest, this method can generate $3,309 more in interest.

Thanks to the compound interest effect, you can earn more with the same amount of money. Also, note that the interest amount varies depending on how frequently the interest is compounded. The more frequently compounding occurs, the more money you'll earn. For example, daily compounding can generate more interest than monthly compounding.

When a financial product offers compound interest, how is its return calculated? This is where Annual Percentage Yield (APY) comes in handy. You can use a formula to convert APR to APY based on the compounding frequency. For example, a 20% APR compounded monthly equates to a 21.94% APY. The 20% APR compounded daily equates to 22.13% APY. These APY figures represent the annualized interest rate return you can achieve after accounting for compound interest.

In summary, APR is a simpler, static metric and is therefore always quoted as a fixed annual interest rate. APY, on the other hand, includes interest earned on interest, which is compound interest. The interest amount varies depending on the frequency of compounding. Here's how you can remember the difference: the Y in APY stands for "Yield," which has five letters, compared to the R in APR, which stands for "Rate." Additionally, compared to "Rate," "Yield" represents a more complex concept (and the yield is relatively higher).

Comparing Different Interest Rates

In the example above, we can see that the compound interest effect can generate more interest income. Different products may present their rates in the form of APR or APY. Given this difference, when comparing different products, make sure to use the same terminology; otherwise, they may not be comparable.

A product with a higher APY doesn't necessarily generate more interest than a product with a lower APR. If you know how often the interest is compounded, you can easily convert between APR and APY using online tools.

The same applies when comparing DeFi and other types of cryptocurrency products. When looking at products that may be advertised using cryptocurrency APY and APR (such as cryptocurrency savings and staking, etc.), be sure to convert them to the same term to make them comparable.

Furthermore, if two DeFi products present yields in the form of APY, when comparing them, ensure they are compounded at the same frequency. This is because even if two products have the same APR, if one product is compounded monthly and the other daily, the product that is compounded daily may generate more cryptocurrency interest.

Additionally, you should be aware of what APY actually means in relation to the specific cryptocurrency product you're considering. Some product guarantees use the term "APY" to represent the cryptocurrency rewards investors can earn within a specific time period, rather than any actual or expected yield expressed in fiat currency. It's important that you carefully distinguish this important distinction because cryptocurrency asset prices can fluctuate, and the value of your investment (in fiat currency) may decrease or increase. If cryptocurrency asset prices decrease significantly, the value of your investment (in fiat currency) may still be lower than your initial investment amount in fiat currency, even if you continue to earn the APY on the cryptocurrency assets. Therefore, you should carefully read the relevant product terms and conditions and conduct your own research to fully understand the investment risks involved in this product and what the APY actually means in this specific scenario.

Summary

APR and APY can be easily confused at first; however, you can easily differentiate between the two by simply remembering that the Annual Percentage Yield (APY) metric takes into account compound interest and is more complex. Due to the compound interest effect of APY, when the frequency of compound interest is greater than once a year, APY is always higher than APR. At the end of the day, when calculating the interest you'll earn, always make sure you're looking at the correct interest rate.

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