Brief content

You've probably seen these two similar-sounding terms, APY and APR, when you've been researching decentralized finance (DeFi) products.

APY, or annual percentage rate of return, takes into account interest compounded quarterly, monthly, weekly, or daily, while APR (annual percentage rate) does not. This simple difference can have a significant impact on the profitability calculations for a given period. Therefore, it is important to understand how these two metrics are calculated and what they mean for the income you can earn from your digital assets.

APR and APY

APR and APY are the main metrics for personal finance purposes. Let's start with a simpler term like annual percentage rate (APR). This is the interest rate that the lender earns on their money and that the borrower pays for using it for one year.

For example, if you top up your bank savings account with $10,000 at 20% per annum, you will receive $2,000 in interest per year. Your interest is calculated by multiplying the principal ($10,000) by the APR (20%). Thus, after a year, you will have a total of $12,000. After two years, your capital will be $14,000. After three years you will have $16,000 and so on.

Before we get to the annual percentage rate (APY), let's first understand what compound interest is. Compound interest means receiving interest on previous interest. In the above example, if a financial institution pays interest on your account every month, your balance will look different for each of the twelve months of the year.

Instead of receiving $12,000 at the end of the 12th month, you will receive interest every month. This interest is added to the principal amount of your deposit and the amount you earn interest on increases over the months. Every month you will have more money that earns interest. This effect is called compounding (or simply compounding).

Let's say you replenished a bank account with $ 10,000 at 20% per annum with monthly interest. Without going into complicated math, you will have $12,429 at the end of the first year. That's $429 more in interest earned, just by adding the compound interest effect. How much interest could you earn with a 20% APR but compounded daily? You would receive $12,452.

The power of compounding is more impressive over longer periods of time. After three years, you'll have $19,309 with the same 20% APR and compounded daily. That's $3,309 more than the income on the same product with an APR of 20% without compound interest.

By simply turning on compound interest, you'll earn a lot more for your money. Also note that interest rates vary depending on how often compound interest is compounded. You earn more when interest is compounded more often. Daily compounding will earn more interest than monthly compounding.

How do you calculate how much you can earn if a financial product offers compound interest? This is where the annual percentage rate (APY) comes into play. You can use a formula to convert APR to APY based on the compounding frequency. 20% APR compounded monthly equals 21.94% APY. Compounded daily, that would be 22.13% APY. These APY numbers represent the annual percentage return you earn after compounding.

That is, APR (annual percentage rate) is a simpler and more static metric: it is always stated as a fixed annual rate. But APY (annual percentage yield) takes into account interest earned on interest or compound interest. APY varies based on billing frequency. One way to remember the difference is to remember that the word "profitability" is 13 letters long (7 more letters than "rate") and is also a more complex concept (and more profitable).

How to compare different interest rates?

From the above example, you can see that you can earn more with interest compounding. Different products may present their APR or APY rates. Because of this discrepancy, it is important to use the same term for comparison. Be careful when comparing products, because you may be comparing apples to oranges.

Products with a higher APY will not necessarily earn higher interest than products with a lower APR. You can easily convert APR and APY using online tools if you know how often the interest is compounded.

The same goes for DeFi and other types of crypto products. When looking at crypto products that may be advertised using APY and APR, such as crypto savings and staking, be sure to convert them so you can compare apples to apples.

Also, when comparing two DeFi products in terms of APY, make sure they have the same interest accrual periods. If they have the same annual interest rate, but one product accrues interest monthly and the other accrues interest daily, then the one that accrues daily may earn you more interest in cryptocurrency.

Another important point to note is what the APY means in relation to the particular crypto product you are looking at. Some products use the term "APY" to refer to the reward that can be earned in cryptocurrency over a selected time period, rather than the actual or projected return/return in fiat currency. This is an important distinction to consider, as cryptoasset prices can be volatile and the value of investments (in fiat money) can go down or up. If the prices of cryptoassets plummet, the value of your investment (in fiat money) may still be less than the initial amount you invested in fiat, even though you continue to earn APY in cryptoassets. It is therefore important that you read the relevant product terms and conditions carefully and do your own research to fully understand the investment risks involved and what the APY means in the specific context of your chosen product.

Results

APR and APY may seem like confusing concepts at first, but they're easy to tell apart when you remember that annual percentage rate (APY) is a more complex metric that takes compound interest into account. Because of the compounding effect on interest, the APY is always a higher number when interest is compounded more than once a year. The bottom line is to always check what rate you're looking at when calculating the interest you'll earn.

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