What is APY and how does it differ from APR in the crypto world

Basic Differences: APR vs APY

When starting to invest in digital assets, you’ll encounter the terms APR and APY all the time. Although these two terms sound similar, they have distinct meanings and impacts on your returns. APR (Annual Percentage Rate) is the simple interest rate that does not account for compounding, whereas APY (Annual Percentage Yield) includes the effects of compounding in its calculation.

This difference may seem minor, but over time, the returns you receive can vary significantly.

What is APR (Annual Percentage Rate)

Definition and Function

APR stands for Annual Percentage Rate, which represents the annual interest rate in the simplest form. If you invest 100 units at an APR of 5%, you will earn 5 units of interest at the end of the year. There is no reinvestment or compounding involved—just the interest on the principal.

In the context of borrowing, if the APR is 5%, it means that for a loan of 100 units, you will pay an additional 5 units of interest that year.

The advantage of APR is that it provides a straightforward and clear picture of the amount of interest you will pay or receive.

Types of APR

Fixed APR (Fixed APR): Your interest rate remains unchanged throughout the period, meaning the amount you pay or receive each year stays the same. The benefit is stability and predictability for planning.

Variable APR (Variable APR): This rate can fluctuate based on market conditions, meaning you might pay more or less depending on various factors on the platform. The risk is that you could end up paying more than expected if the market is volatile.

APR in the Crypto Industry

In the digital world, APR indicates the total returns you can expect from staking or lending over a year.

Since APR does not consider compounding, it allows investors to straightforwardly calculate expected returns. For example, if you invest 1 ETH in a DeFi platform with an APR of 24%, you will earn 0.24 ETH in interest by the end of the year, making your total 1.24 ETH.

What is APY (Annual Percentage Yield)

Definition and How It Works

APY stands for Annual Percentage Yield, which differs from APR in that it incorporates the effects of compounding interest. With compounding, you not only earn interest on your principal but also on the accumulated interest.

This is why APY often yields higher returns than APR when comparing at the same interest rate.

APY in the Crypto Context

In the crypto industry, APY is a true indicator of how much your investment will grow, as compounding can occur multiple times per year. (Some platforms compound daily), which accelerates your gains.

For example, an interest rate of 6% can be converted to APY as follows:

• 6.09% (compounded semi-annually)
• 6.14% (compounded quarterly)
• 6.17% (compounded monthly)
• 6.18% (compounded weekly)
• 6.18% (compounded daily)

As seen, daily compounding yields the highest return.

Using APR and APY in Crypto Investment Tools

Staking: Making Your Money Idle

Staking is the process of locking your digital assets on a blockchain network to support its operation, and in return, you earn rewards in the form of crypto coins.

This is a popular passive investment tool among crypto investors because you can generate income simply by holding coins. Some DeFi platforms even offer daily interest payments, meaning your returns increase every 24 hours.

Yield Farming: Growing Profits

Yield Farming is similar to staking but involves different mechanisms. Here, you provide your tokens to a liquidity pool via a dApp.

By doing so, you supply liquidity to the platform and earn rewards set by the protocol. Yield farming often offers higher returns than regular staking but also carries higher risks.

How to Calculate APR and APY

Basic APR Calculation Formula

Calculating APR is quite straightforward:

APR = P × T

where:

• P = interest rate per period (expressed as a percentage)
• T = investment period (in years)

Example of APR Calculation

Suppose you want to invest 10 BTC at an APR of 6%:

• P = 6% × T = 1 year = 6%
• After one year, you will earn 0.6 BTC, making your total 10.6 BTC.

If the APR is expressed as a monthly percentage (0.5% per month):

• P = 0.5% × T = 12 months = 6%
• The result remains 6% APR annually.

Whether you calculate monthly or yearly, the outcome is the same.

APR Calculation Formula for APY

Since APY accounts for compounding interest, its formula is more complex:

APY = ((1 + r/n)^n - 1)

where:

• r = interest rate per period (expressed as a decimal)
• n = number of compounding periods per year

Because this formula is more complex, you can use online calculators or APY calculators to help compute it.

Is APY Better Than APR?

Key Differences

Recommendations for Different Users

If you are an investor or lender, you should always choose APY because compounding accelerates your wealth growth. Over time, the difference between APR and APY becomes significant.

However, if you are a borrower, focus more on APR, as it indicates the actual cost you will pay. With APR, you can easily find the “best interest rate.”

Real-Life Example for Clarity

Suppose you invest 10,000 units in a high-yield account with a APR of 5% per year:

Using APR only:

• Year 1: interest = 500 units
• Year 2: interest = 500 units
• Year 3: interest = 500 units
• Total after three years: 11,500 units

Using APY 5% with annual compounding (compounded yearly):

• Year 1: 10,000 × 1.05 = 10,500 units
• Year 2: 10,500 × 1.05 = 11,025 units
• Year 3: 11,025 × 1.05 = 11,576.25 units
• Total after three years: 11,576.25 units

The difference is 76.25 units. While small over three years, as the period or investment amount increases, the gap becomes more significant.

Summary

Understanding APR and APY is crucial for making informed investment or borrowing decisions. While APR provides a clear picture of the actual interest paid or received, APY reflects the true growth of your investment, especially when compounding is involved.

In the crypto industry, returns are often higher than traditional markets but come with higher risks. Therefore, carefully consider APY when choosing staking or yield farming strategies to optimize your investment planning and maximize returns.