You might have seen the terms APR and APY in the crypto and DeFi space — but have you ever wondered what they exactly mean, and what the difference between the two is? Learn more below.
In this article, we dive into the two common metrics used to represent returns on crypto investments and finds out: what exactly is the difference between the two?
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What Is APR (Annual Percentage Rate)?
Often, it is used on loans, credit cards, mortgages and investments. Using a simple example, if John’s $10,000 bank account has an annual interest APR of 15%, he will get $1500 in interest after one year.
What Is APY (Annual Percentage Yield)?
Understanding Compound Interest and Interest Rates
Instead of getting $1,500 at the end of the year, John gets some interest each month. Assuming he does not withdraw the interest earned, his bank account will therefore grow slightly every month.
At the same time, the interest will be calculated on that larger balance month after month. As a result, the interest payment grows slightly larger each time.
This is called the compounding effect.
APR vs APY Example
Remember in the first example, John's bank account gives an APR of 15%? Now, assume that the nominal interest rate — that is, the base rate that does not include compounding — is also 15%.
Note: there is a difference if the nominal rate is 15% versus the APY being 15%, if the latter is 15%, then John would have earned a similar amount of interest as the first example.
The effect becomes especially large over larger periods of time. If John locks his account for three years, he will make $5,639.44 in interest over the period with compounding, and just $2,479 without it.
This is why Einstein once said:
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.”
Are APR and APY the same thing?
To put it simply: no, they are not.
APR is a simpler metric; it shows a constant yearly rate. APR is often shown as the amount of interest on personal loans or credit card debt.
APY shows yearly rates too, but also includes compounding effects. The APY will go up or down, depending on how often the compounding takes place. The frequency of compounding is also called the compounding period.
In John’s case, weekly interest payments will result in a higher APY, whereas quarterly payments will push it down.
How to Calculate APR?
The APR is usually a given, but it can be calculated using the interest per compounding period as well. Note that the number of periods in a year can also be less than 1, in the rare case interest is paid less than once a year. The formula for calculating APR is as follows:
APR = (interest rate per compounding period * number of periods in a year)
How to Calculate APY?
APY is calculated as seen in the formula below. In the calculation, pay attention to the compounding periods, you have to calculate the interest rate per period (say week, or month), rather than using the standard yearly rate.
APY = (1 + Nominal Interest Rate/No. of compounding period per year)ˆNumber of periods – 1
Exploring 0% APR
0% APR allows you to borrow at zero percent interest rates. The popular concept from the credit card world has reached crypto too. Users can borrow against their crypto without paying interest, so long as their collateral has enough value. Protocols limit their risk by requiring more collateral than the borrowed amount.
Examples of APR and APY in Crypto
The same is true for Crypto.com, who explicitly state that the rewards you receive is a simple daily reward rate which will not be compounded. Both platforms provide stable rewards for locking up your coins.
When you dive into the less well-travelled areas of crypto-land, you can find ridiculous APYs, at the cost of significantly higher risk. The screenshot below is from a yield farm on Arbitrum. The author of this article participated in this strategy during the peak of the bull market, when it generated a whopping 41 million percent in APY (yes, you read that correctly). It doesn't take a genius to figure out that these yields are not sustainable, and they quickly came down.
Nevertheless, the author doubled his staked amount in the course of 36 hours. Again, these ultra-high APY farms are incredibly risky, and should not be participated in without due regard for risk.
What Is Better — APR or APY?
There is a time and place for everything. This is true for the APR vs APY debate as well. In some cases, APR is the more relevant metric, whereas other situations call for APY. This mostly depends on whether you are the borrower or the lender.
The Borrower's Perspective
As a borrower, you are paying off the balance as you go. Whether you are paying off a personal loan or credit card debt, there is no compounding effect to increase the total cost of borrowing; and APR makes more sense. The same is true for crypto loans, where you’re paying off a debt as you go.
The Lender's Perspective
In a situation where you are lending (saving) your money, compounding effects do take place, as interest is being paid over previously earned interest as well. In these situations, knowing the APY rate is great, as it gives you a more detailed insight in the total returns on your capital.
The Bottom Line
When comparing different yields, it is important to compare them objectively. One protocol might present the yields in APR, whereas the other protocol will tell you the APY.
Many yield farms boast high APY rates, referring to the percentual rewards generated in an altcoin, rather than the actual fiat value of these rewards. This is a crucial factor, as crypto prices can be volatile, and the value of the rewards can fluctuate significantly. This can significantly boost or hamper your real return.
One thing you can do is to convert all APR rates to APY, so that you can compare each product objectively, and ascertain the correct APY rates for the risk of the token it is being paid in.
A final factor to consider is counterparty risk. Higher than average yields are often paid to compensate for higher-than-average risk. It is very important to review the different crypto protocols, and to do your own research before apeing in.