2 August 2023
When researching decentralized finance (DeFi) solutions, you have probably come across the phrases APY and APR, which have a similar sound.
Unlike APR, which stands for annual percentage rate, APY includes interest that is compounded quarterly, monthly, weekly, or daily. Calculations for returns over time may be significantly altered by this seemingly little distinction. It is crucial to comprehend how these two measures are determined as well as what it means for the potential returns on your digital investments.
For the purposes of personal finance, APR and APY are both essential metrics. Let's start with annual percentage rate (APR), which is less complicated. It is the interest rate that a lender receives on their investment over the course of a year and that a borrower pays to use it.
For instance, if you deposit $10,000 into a bank savings account with a 20% APR, after a year you will receive $2,000 in interest. By multiplying the principal ($10,000) by the APR (20%), your interest is determined. So you will have a total of $2,000 after a year. Your initial investment will grow to $14,000 after two years. You will have $16,000 in three years, and so on.
Understanding compound interest can help us better grasp annual percentage yield (APY). Simply put, it refers to receiving interest on interest already received. If the financial institution pays interest to your account on a monthly basis, as in the previous example, your balance will change throughout the course of the year.
You will receive a portion of the interest each month rather than $12,000 at the conclusion of the 12th month. The amount on which you receive interest increases as the months go by since this interest is added to the deposit's principal amount. You will have more money collecting interest each month. Compounding is the term for this outcome.
Consider depositing $10,000 in a bank account with a 20% APR and monthly compounding interest. You will receive $12,194 at the conclusion of a year, without delving into the intricate calculations. Simply by multiplying the impact of compound interest, that amounts to an additional $194 in interest. How much interest you would make if the APR was exactly 20% and interest was compounded daily? You would then receive $12,213.
Over longer time frames, compounding's power is more striking. With the same 20% APR product and everyday compounding, you would have $19,309 at the end of three years. In comparison to the identical 20% APR product without compounding, it is $3,309 more interest collected.
You may increase your income significantly by merely using compound interest. Also take note of how the interest varies depending on the frequency of compounding. When compounding occurs more frequently, you earn more. You'll earn more income from daily compounding than from monthly compounding.
How can you figure out how much you can make using compound interest on financial products? The annual percentage yield (APY) enters the picture here. Based on the frequency of compounding, an APR can be changed to an APY using a formula. A 20% APR with monthly compounding results in an APY of 21.94%. It would equal 22.13% APY with daily compounding. These APY figures show the annualized interest returns you receive after taking compound interest into account.
In conclusion, APR (annual percentage rate) is a more straightforward and constant metric: It is consistently stated as a fixed annual rate. However, APY (annual percentage yield) includes compound interest, or interest gained on interest. Depending on the frequency of compounding, it alters. The fact that "yield" has five letters (one more than "rate") and denotes the more sophisticated notion (and higher revenues) can help you recall the differences.
You can see from the example above that interest can be compounded to yield extra interest. Rates for various items may be displayed as either an APR or an APY. It is crucial to compare using the same phrase due to this disparity. When comparing products, be careful because you can be comparing apples and oranges.
There is no guarantee that products with a higher APY will earn more interest than those with a lower APR. If you know the frequency of compounding, using internet tools to convert APR and APY is simple.
DeFi and other types of crypto goods are the same way. To compare like with like when looking at items that might advertise using crypto APY and APR, such as crypto savings and staking, be sure to convert them.
Make sure that the compounding periods are the identical when comparing two DeFi products with APY. If they both have the same APR but one compounds daily and the other monthly, you could be able to earn more money on your cryptocurrency using the daily compounding option.
What APY means in relation to the particular crypto product you are analyzing is another crucial thing to keep in mind. Rather than the actual or anticipated returns/yield in any fiat currency, certain product collaterals use the word "APY" to refer to the rewards that one can earn in cryptocurrencies throughout the chosen timeframe. This is a crucial point to understand because the value of your investment (in fiat terms) may increase or decrease depending on the volatility of crypto asset prices. Even if you continue to earn an APY in crypto assets, if the price of crypto assets falls sharply, the value of your investment (in fiat terms) may still be lower than the initial amount you placed in fiat. As a result, it is crucial that you carefully read the applicable product terms and conditions and conduct your own research to fully comprehend the investment risks involved and what APY means in that particular situation.
APR and APY may initially seem similar, but it's simple to distinguish one from the other by keeping in mind that annual percentage yield (APY) is the more complicated metric that takes compound interest into account. When interest is compounded more frequently than once a year, the annual percentage yield (APY) is always larger due to the effect of earning interest on interest. The key is to always double-check the rate you are using when estimating the interest you would earn.
Disclosure and Risk Caution: Without any representation or warranty of any kind, this content is provided to you on a "as is" basis solely for educational and informational reasons. It is not meant to be taken as financial advice or as a suggestion to buy a particular good or service. For further information, please read our entire disclaimer. Prices for digital assets can fluctuate. Your investment's value could increase or decrease, and you could not get your money back. Your investment choices are entirely your responsibility, and Metavest is not accountable for any losses you might sustain nor monetary guidance.