Understanding the terminology used in DeFi is crucial, and two terms that often come up are APY and APR. These terms sound similar but have distinct meanings. While APY stands for annual percentage yield, APR stands for annual percentage rate.
APY factors in the interest that is compounded daily, weekly, monthly, or quarterly. APR, on the other hand, does not account for compounding interest. Due to this difference, the calculation of returns over time can vary significantly. Therefore, comprehending the calculation methods of both these metrics is crucial to gauge the potential returns on digital assets.
APR vs. APY
APR: Annual Percentage Rate
In the realm of personal finance, two fundamental terms are APR and APY. To begin, APR is a relatively straightforward concept, representing the annual interest rate that a lender earns and a borrower pays over one year. For example, depositing $10,000 into a savings account with a 20% APR would result in $2,000 in interest after one year, calculated by multiplying the principal amount ($10,000) by the APR (20%). Therefore, your balance would be $12,000 after one year, $14,000 after two years, $16,000 after three years, and so on.
Understanding compound interest is crucial to comprehending APY. It refers to earning interest on previously earned interest. If a financial institution pays interest on your savings account every month, your account balance will change each month. Rather than receiving a lump sum of $12,000 at the end of the year, you will receive interest each month. The interest amount is added to your principal balance, and the amount earning interest increases with each passing month. This effect is called compounding.
For example, depositing $10,000 in a bank account with a 20% APR and monthly compounding would result in $12,194 after one year. Simply by incorporating the effect of compound interest, an additional $194 in interest would be earned. If the same 20% APR product had daily compounding, the interest earned would be $12,213. Compounding interest's power becomes more evident over longer periods. After three years, the account would hold $19,309 with the same 20% APR and daily compounding, $3,309 more interest earned than without compounding.
APY: Annual Percentage Yield
The frequency of compounding determines the amount of interest you earn, with daily compounding resulting in a higher return than monthly compounding. To calculate the potential earnings of a financial product that utilizes compound interest, you can convert the APR to the APY using a specific formula. For example, a 20% APR with monthly compounding equates to a 21.94% APY, while daily compounding increases the APY to 22.13%. The APY represents the total interest returns you earn in a year, incorporating compound interest.
To summarize, APR is a simple and fixed yearly rate, while APY incorporates compound interest and changes according to the frequency of compounding. A way to differentiate between the two is to remember that “yield” represents a more complex concept and can potentially result in greater earnings.
How to Compare APR and APY?
It's crucial to use the same term to compare financial products because rates can be presented as either APR or APY. As shown in the previous example, compounding interest can result in higher earnings. However, a higher APY doesn't always mean more interest earned compared to a lower APR. To accurately compare products, it's crucial to convert rates to the same term, which can be done easily using online tools if you know the compounding frequency. Be cautious when comparing products, as different terms may lead to misleading comparisons.
It's important to convert crypto APY and APR to the same term to compare DeFi and other crypto products accurately. For example, when evaluating crypto savings and staking products, convert their advertised rates to the same term for comparison. Additionally, ensure that the compounding periods are the same when comparing two DeFi products with APY. If two products have the same APR, but one compounds daily and the other monthly, the one with daily compounding will generate more crypto interest.
When assessing a specific crypto product, it's essential to understand what APY means to that product. Some product materials may use the term “APY” to describe the rewards you can earn in cryptocurrency over a certain timeframe, rather than the actual or projected returns/yield in any fiat currency. This is crucial to recognize because crypto asset prices can be volatile, meaning the value of your investment (in fiat terms) may fluctuate.
If crypto asset prices decline significantly, the value of your investment (in fiat terms) may still be lower than your initial investment amount, even if you continue to earn an APY in crypto assets. As a result, it's important to carefully review the relevant product terms and conditions and conduct your own research to fully grasp the investment risks involved and what APY means in that specific context.
Different financial products may present their interest rates as either APR or APY, and it is crucial to understand the difference between the two. Remember that APY incorporates compound interest, making it a more complex metric than APR. As a result, when interest is compounded more frequently than once a year, APY will always be higher than APR due to the effect of earning interest on interest. Therefore, it is essential to check which rate you are looking at when calculating the interest you would earn. Initially, APR and APY may seem confusing, but understanding the difference is crucial when comparing different financial products.