Annual percentage rate (APR) and annual percentage yield (APY) are two important financial concepts that can have a significant impact on your financial decisions, particularly when it comes to investing in crypto assets. APR represents the amount of interest charged on a loan over the course of a year, while APY represents the total amount of interest earned on an investment over the course of a year.
While both APR and APY involve the concept of interest, the key difference between the two is the way in which interest compounds.
APR is a fixed yearly rate that doesn’t take into account the compounding of interest, while APY includes the compounding of interest and can be impacted by the frequency at which interest is added to the principal amount of the investment.
Still confused? Don’t worry, you’re not alone. Even though these two terms might sound similar, they can actually have a big impact on your financial decisions.
In this article, we’ll break down the definitions of APR and APY, explain how they’re calculated, and highlight some key differences between the two. We’ll also explore how these concepts apply to the world of crypto assets and DeFi protocols. By the end, you’ll have a better understanding of how to compare rates when considering different crypto products.
So, let’s get started.
What is APR?
APR stands for annual percentage rate. It represents the amount of interest charged on a loan over the course of a year.
When you take out a loan, whether it’s a personal loan, a mortgage, or a credit card balance, you’ll typically be charged an APR.
APR is calculated using a fairly simple formula:
APR = (interest rate / number of compounding periods) x number of periods per year
For example, let’s say you take out a personal loan with an interest rate of 12% and monthly repayment periods. The APR on this loan would be calculated as follows:
APR = (12% / 12 months) x 12 months = 12%
In other words, the APR on this loan would be 12%. This means that you would be charged a total of 12% interest on the loan over the course of a year.
What is APY?
APY stands for annual percentage yield. It represents the total amount of interest earned on an investment over the course of a year.
When you put your money into a savings bank account, a certificate of deposit (CD), or a crypto savings account, you’ll typically earn an APY on your deposit.
APY is calculated using the following formula:
APY = (1 + interest rate / number of compounding periods) ^ (number of compounding periods per year) - 1
For example, let’s say you open a deposit account with an interest rate of 12% and monthly compounding periods. The APY on this account would be calculated as follows:
APY = (1 + 12% / 12 months) ^ (12 months) - 1 = 12.68%
In this case, the APY on the deposit account would be 12.68%. This means that you’d earn a total of 12.68% return on your deposit over the course of a year.
Note how the APY was higher than the APR in this example. This is always true. APY will always be equal or higher than APR. APR is more intuitive but APY captures the true return or cost.
APY can be impacted by a number of factors, such as the compounding frequency (e.g. daily, weekly, monthly) and the initial investment.
Key differences between APR and APY
So, what’s the main difference between APR vs. APY? Essentially, it boils down to the way in which interest compounds. This is an important distinction.
APR is a fixed yearly rate that doesn’t take into account the compounding of interest.
On the other hand, APY includes the compounding of interest, which means that the APY takes into account the frequency at which interest is added to the principal amount of the investment.
Understanding compounding will change how you optimize your crypto investments
The easiest way to understand the difference is through an example.
Say I invest $10,000 in a scheme that pays me $100 every month. This means I get 1% every month. At the end of 12 months, I will have my initial $10,000 plus 12*$100=$11,200.
So that sounds like a return of 12% right?
Consider what happens after month 1. The $100 I received in interest is also getting added to the savings scheme. This means that the $100 will also earn 1% in interest in the next month.
So I will have
- $10,000 + $100 in Month 1
- Then in Month 2, I will have $10,100 + 1%*10,000 + 1%*$100= $10,201
- In Month 3, I will have $10,201 + 10,201*1% = 10,201 *(1.01)=$10,303
- In Month 4, I’ll get $10,303*(1.01)=10,406
- You can see where I am going with this. I can generalize this pattern up to a formula. For example, Month 4 is 10,000 *(1.01)*(1.01)*(1.01)*(1.01)=10,000*1.01^4
- So the total return after 12 months is 10,000*1.01^12=$11,268.
- Percentage-wise this is 11,268-10,000/10,000= 10,000*1.01^12-10,000/10,000 = 1.01^12-1 which is precisely the APY formula I showed you in the previous section.
In the table below is the return month by month:
|Month||Return in $|
To summarize, after 12 months you have $11,268 which is a return of 12.68% vs. the original assumption we made of 12%. 12% was intuitive to understand but did not take compounding into account.
The secret that savvy crypto investors know
Compounding can be massively impactful on your wealth. And this is what savvy crypto investors know better than naive investors.
Take a look at this analysis by one of my favorite blogs: PlainEnglishFinance.com. Assume you have $5,000 to invest in a savings scheme and that you top it up with an additional $250 every month.
If you were to hide the money under your mattress and receive 0% interest you would have a nice sum of $95,000 after 30 years.
But, had you invested in a scheme that paid 8% then you would have more than 4 times as much! And if the return was 20% then you would have a whopping $7.8Mn.
So, yes, the rate of return matters but what is more important is the fact that you re-invest your return and take advantage of the power of compounding.
Understand the time value of money and you will master the universe
Now think about this for a second. Pay attention because this is one of the most important concepts in crypto and finance more broadly.
What is the difference between paying a loan installment every month and paying the total lump sum at the end? They both have an annual interest rate of 12%
If I take out a $100K loan I can either pay $1K every month in interest or I can pay $12K in interest at the end of the period.
Let’s forget about the principal payments for a while. Say in both cases you pay the principal at the end of 12 months.
Which one do you prefer? Do you prefer to pay $1K in interest every month or $12K at the end of the year?
If you have been paying attention and are financially savvy you should prefer the second option. This is because you could use that $1K per month and put it to better use. For example, you could invest it in a crypto liquidity pool or a savings account in a bank and earn a return. This aspect is called the time value of money.
Paying frequent installments to the lender is good for the lender and bad for you. In order to properly assess what is happening you need to look at the APY.
Effective vs. nominal rates of interest
Imagine a bank lends you $10,000 on their credit card. They quote you an interest rate of 12% and ask you to pay interest in monthly installments over a year. So every month you pay $100 in interest.
The interest rate they have quoted you is the APR. At the end of the year, you will have paid 11,200 back to the bank. The APR that they quoted you is also known as the nominal interest rate.
However, you should be aware that the effective interest rate is 12.68% as we calculated above. And the reason for this is that you could be using that $100 to invest it somewhere else in the meantime. Or, if you flip this around, the bank is taking that $100 every month and reinvesting it to get 12% by lending it to someone else.
If you want to be financially savvy then you should be considering the time value of money and try to understand what the APY on a loan is.
In Europe, it is compulsory to disclose the APY for interest rates on loans. Another word for APY is the effective interest rate. While APY is less intuitive to grasp, it is a more robust way to account for the cost of a loan. In the US however, banks are only mandated to disclose the APR.
In all honesty, most of us are not so organized and may not always invest any leftover cash we have. Thus the notion of the time value of money is somewhat theoretical when it comes to borrowing. When it comes to saving it makes complete sense because your default is to not take any action and let the interest you have earned continue to compound.
How to compare crypto loans
However, APY is very useful for comparing loans when they have differing repayment frequencies.
How do you compare a 6-month loan with weekly installments vs. a 12-month loan with monthly installments vs. a revolving line of credit that only required you to pay the loan plus interest at the end of the year? The most objective way to compare these would be to use an APY. This would account for the differing payment timelines and frequencies.
Having said that, financial institutions will usually quote an APR for loans and an APY for products that offer a yield. This is because they want loans to appear cheap and savings rewards to appear lucrative.
The role of compounding for APR vs APY
Compounding interest is a powerful concept that can have a big impact on the amount of interest earned or charged over a given period of time. Essentially, compounding interest means that the interest earned on an investment (or charged on a loan) is added to the principal amount, which then earns more interest in the future.
Frequency of compounding
The frequency at which interest compounds can have a big impact on the final amount of interest earned or charged. For example, daily compounding will result in a higher final amount than monthly compounding, all else being equal. This is because the interest is being added to the principal more frequently, leading to a higher overall return (or cost).
It’s worth noting that the power of compounding can work against you as well.
For example, if you have a high balance on a credit card with a high APR and daily compounding, the compounding effect can lead to a much higher total cost of interest over the life of the loan. This is why it’s important to pay off high-interest debt as soon as possible and shop around for the best rates when considering financial products.
APY and APR in the crypto world: yield farming
With the advent of decentralized finance (DeFi), people started to seek the best ways to earn interest, otherwise known as yield, by putting their crypto assets into various products. There are 4 main ways to earn a passive income yield in crypto.
- Staking: You provide your tokens to a validator who is responsible for checking and adding blocks to a PoS blockchain. In return for doing this, the validator is rewarded with newly minted tokens some of which are shared with you. To understand staking I recommend you read up on Ethereum
- Liquidity pools. You buy an equal amount in value of two tokens and put them in a liquidity pool on a decentralized exchange such as Uniswap. You get a cut of the trading fees whenever traders swap one asset for another in the pool you have joined. If you want to understand liquidity pools in detail I recommend you read my breakdown of Uniswap.
- Lending: You provide your crypto assets to a lending platform and earn a yield for doing so. The most famous lending and savings protocol is Compound crypto.
- Crypto savings accounts: these are effectively the same as lending but they are packaged as savings accounts.
Due to the multitude of products in DeFi, people could become quite sophisticated in their strategies and the sector got nicknamed “yield farming”. As the industry evolved so did the products.
You now have DeFi solutions in crypto that help you compound more efficiently or find the highest yield. Here are a couple of examples:
- Yearn Finance is a DeFi protocol that allows you to optimize your investment allocation across a bunch of protocols. Imagine you don’t want to buy a crypto asset and are only willing to invest in stablecoins because they are less volatile. Now, you can choose to invest in a multitude of yield-generating protocols. The options are endless. The problem is yields keep changing. Yearn finance automatically optimizes your investment so that it automatically finds where the higher interest rates are for your stablecoins. You can learn more about Yearn here.
- Beefy Finance is a decentralized protocol that automatically compounds returns for you. While people can invest manually and take their rewards and reinvest them in the scheme this is not very efficient. Beefy automates the process.
Beefy and Yearn are known as yield aggregators. There are loads of other protocols that do that same.
It’s important to keep in mind that investing in crypto assets comes with inherent risks, and it’s crucial to do your own research and compare APY rates across different platforms before making a decision. It’s also worth noting that the crypto market can be highly volatile, and the value of your investments can fluctuate significantly over time.
In summary, APR and APY are important financial concepts that can have a big impact on your financial decisions. APR represents the annual percentage rate or the amount of interest charged on a loan over the course of a year. APY represents the annual percentage yield or the total amount of interest earned on an investment over the course of a year.
The main difference between APR and APY is the way in which interest compounds. APR is a fixed yearly rate of interest that doesn’t take into account the compounding of interest, while APY includes the compounding of interest and can be impacted by the frequency at which interest is added to the principal amount of the investment.
It’s important to understand these concepts when considering different financial products, whether in the traditional finance world or the crypto space. The power of compounding can have a big impact on the final amount of interest earned or charged over a given period of time, and it’s crucial to compare rates and do your own research before making a financial decision.
As always, it’s important to carefully consider the risks and rewards of any financial product before investing your hard-earned money. Whether you’re looking for a personal loan, a high-yield investment, or a crypto savings account, make sure to do your own research and compare rates before making a decision.
If you liked this article you may also want to understand why crypto is worth anything in the first place.
FAQs on APR vs. APY
Is APR or APY better crypto?
APY is a more robust way to compare crypto products as it includes the time value of money. APY take the compounding frequency into account whereas APR doesn’t.
Is APY higher than APR?
Yes, APY takes into account the effect of compounding so it will always be higher or equal to the APR.
How is APY so high for crypto?
The APY for crypto products is usually denominated in the currency of the protocol or blockchain you are investing in. Since many protocols can print as many tokens as they like, they can promise you astronomical returns. Whether these will hold any value is a completely separate debate.
Is a bigger APY better?
Yes, if you are investing in a savings scheme the bigger the APY the more returns you earn. But you need to be careful what you are being paid in. If it’s a token whose value will be zero in a few years then astronomical APYs may be too good to be true. On the flip side, the lower the APY on a loan the better for the borrower.