APY vs APR — What Do They Mean?

Learn the differences between Annual Percentage Yield (APY) and Annual Percentage Rate (APR) in the crypto market.

What Is APY and APR in the Crypto Market?

Understanding Annual Percentage Yield (APY) and Annual Percentage Rate (APR) is crucial for navigating the cryptocurrency market. These two metrics, commonly used in decentralised finance (DeFi) and traditional finance (TradFi), help traders evaluate borrowing costs and investment returns. 

In this article, we break down their differences, how they’re calculated, and why they matter for traders’ financial decisions.

What Is APY?

APY is the total amount of interest a trader earns on an investment over one year, taking into account the effect of compound interest. Unlike simple interest, compound interest means a trader earns interest not only on their initial investment, but also on the interest they’ve already earned.

Think of it like a snowball rolling down a hill — as it rolls, it picks up more snow, making the snowball bigger, which in turn helps it collect even more snow. Similarly, with compound interest, money grows faster because it’s earning ‘interest on interest’.

For example, if someone invests $1,000 in an account with a 10% APY, they’ll have $1,100 after one year if the interest compounds annually. However, if the interest compounds monthly, they’ll end up with slightly more because they’re earning interest 12 times per year on an increasingly larger balance.

In DeFi, APY rates tend to be higher than traditional banking but are usually variable, meaning they change based on market conditions. Some DeFi platforms might offer APYs ranging from 2% to 20% or even higher, though these rates can significantly fluctuate based on supply and demand for different cryptocurrencies.

What Is APR?

APR represents the simple annual interest rate on a loan or investment without taking into account the effects of compounding. It’s essentially the basic interest rate someone pays on a loan or earns on an investment over one year.

Unlike APY, APR doesn’t account for compound expenses accrued by the borrower. For example, if someone has a loan with a 10% APR and monthly payments, their effective interest rate (APY) will be higher because they’re paying interest monthly. This is why APR is often called the ‘nominal’ rate, while APY is considered the ‘effective’ rate, which includes the compounding interest.

In traditional finance, APR is commonly used for mortgage loans, credit cards, and car loans. Lenders are legally required to disclose the APR to help consumers compare different loan offers. For instance, a credit card might advertise a 12% APR, but if interest compounds monthly, the actual amount a holder pays (the APY) would be about 12.68%.

In DeFi, platforms often display both APR and APY to give users a complete picture of potential returns. For example, a lending protocol might show an APR of 10% but an APY of 10.47% if interest is compounded daily. Understanding the difference between APR and APY is crucial for accurately comparing different investment or borrowing options.

What Are the Key Differences Between APY and APR?

The key differences between APY and APR reflect how interest is calculated and displayed in financial products. Let’s break this down:

APY shows the total return over a year when accounting for compound interest. This means it includes the interest someone earns on their initial investment, plus the interest earned on their accumulated interest. APY is typically used for savings accounts, investments, and deposits, especially in DeFi lending and staking platforms. It gives a more accurate picture of what someone could earn.

APR is a simpler calculation that shows the basic interest rate without considering compounding effects. This is commonly used for loans, mortgages, and credit cards. For example, if a credit card has a 15% APR, that’s the basic interest rate, but the actual cost of borrowing (the APY) will be higher due to monthly compounding.

The relationship between the two is important: For the same interest rate, APY will always be higher than APR unless there’s no compounding. For instance, a 10% APR compounding monthly results in about a 10.47% APY if we do not consider their different usages — APY for interest income and APR for cost. In DeFi, platforms often use APY to show potential earnings from lending or staking, while APR is used to display borrowing costs.

Regulators require lenders to disclose APR for loans to help consumers compare different loan offers, while investment products typically advertise APY to show potential returns. 

Understanding this difference is crucial for making informed financial decisions, whether in traditional finance or DeFi.

Remember: The key difference is that APY includes the effect of compounding interest, while APR does not. This is why APY will always be higher than APR for the same stated interest rate (except when there’s no compounding; in which case, they’re equal).

Which Is Better: 10% APY or 10% APR?

10% APY is better than 10% APR for investors/lenders, as they’ll earn more money. 

Here’s why:

With 10% APY, they’re earning a 10% annual return, including compound interest. This means if they invest $1,000, they’ll have $1,100 after one year.

With 10% APR, they’re earning 10% simple interest that doesn’t compound. Depending on how often the interest is paid out (monthly, daily, etc.), their actual returns will be lower than 10% APY. For example, with monthly compounding, a 10% APR would give them approximately a 9.57% actual return over a year.

However, if they’re the borrower, a 10% APR loan is better than a 10% APY loan, as they’ll pay less in interest. 

This is why:

— 10% APR loan: They’re paying a simple 10% interest rate

— 10% APY loan: This equals a 10% interest rate with a compounding effect

This is also why credit cards and loans advertise APR (the lower number), while savings accounts and investments advertise APY (the higher number) — each is trying to make their rates look more attractive to customers.

Conclusion: Mastering APY and APR in the Crypto Market

Understanding the difference between APY and APR is essential for making informed financial decisions in the crypto market. APR provides a straightforward view of simple interest, often used to calculate borrowing costs, while APY reveals the power of compound interest, highlighting potential returns from lending and staking.

In the world of DeFi, where platforms often advertise both metrics, knowing how they work helps to accurately compare opportunities and optimise a trader’s financial strategy. Whether borrowing or investing, mastering these concepts ensures traders are equipped to make choices that align with their goals in the fast-paced and innovative world of crypto.

Due Diligence and Do Your Own Research

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