The Crypto market is full of various crypto products that use different types of interest rates. In particular, there is the APR (Annual Percentage Rate) and APY (Annual Percentage Yield). This guide will show you the differences between an APR and APY rate, as well as explain the link between APR/APY and crypto.
Things to know to get the most out of this guide:
- How to calculate APR and APY?
- What are the differences between APR and APY?
Things to know before commenting on this guide:
No prior knowledge is required to read and understand this comparison between APR and APY
You must have seen at least one or more home or consumer loan ads on TV. You probably also know that the loan rate is a big deal as it determines how much the loan will cost. But what rate are we talking about exactly? There are several rates in the world of crypto. More specifically, there are two main rates: APR (Annual Percentage Rate) and APY (Annual Percentage Yield). This Tokize guide will show you the differences between an APR and APY rate, as well as explain the link between APR/APY and crypto.
What is the Annual Percentage Rate (APR)?
APR is an acronym that stands for “Annual Percentage Rate”. It is the most straightforward interest rate to express how well an investment is performing over a period of one year.
The APR is expressed as a percentage that shows how much interest an investment will generate over a given period.
APR is used in many areas, not just in the crypto sector. For instance, the top personal loan lenders in the US like LightStream, Happy Money, and SoFi offer APRs ranging from 7% to a little over 25%, depending on the loan amount and other factors.
How is APR calculated?
The APR is calculated from the periodic interest rate and how many times it is charged in a year. See the formula below:
APR = Periodic interest rate x Number of periods in the year
In most cases, the interest rate is calculated for the whole year, where the APR is then equal to the annual interest rate. But, the interest rate can also be set for shorter periods: semi-annual, quarterly, or monthly.
Here is how the APR is calculated based on the periodicity of the interest rate:
APR = Annual Interest Rate
APR = Semi-Annual Interest Rate x 2
APR = Quarterly Interest Rate x 4
APR = Monthly Interest Rate x 12
To find out the Total amount of an investment after one year based on its APR, you can use this formula:
Total amount after one year = Initial amount x (1 + APR)
What is Annual Percentage Yield (APY)?
Now let’s move on to the APY, or “Annual Percentage Yield”. This time, we are no longer talking about “simple” interests as in the case of the APR. The APY on the other hand takes into account what is called “compound” interest. To have a clearer understanding of the distinction between APR and APY, you need to know the difference between simple interest and compound interest.
Simple interest is paid at the end of each period (generally every year) and remains separate from the initial amount invested. Compound interest, on the other hand, is regularly added to the capital and will generate interest in the following periods. This repetitive process creates a cycle of accumulating interest.
Considering this explanation, it’s clear that when it comes to interest-bearing savings, compound interest earns investors more money compared to simple interest. Of course, this is assuming the rates are the same, and all other factors are equal.
These two types of interest are not only used for saving money but also when you take out a loan. From the explanation of compound and simple interests earlier, it can be determined that when the period ends, the compound interest will be higher than the simple interest. Alternatively, this indicated that if you opt for a loan with compound interest, it will eventually cost you more than a loan with simple interest, even if the rates are the same.
Ultimately, the type of interest you has a significant impact on your return on an investment or how much you have to pay back on a loan. This impact is evident in the annual rate of the transaction. While the APR indicates the return with simple interest, the APY on the other hand, factors in compound interest.
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How is APY calculated?
Similar to the APR, the APY is calculated based on how frequently interest is compounded. In other words, the APY depends on how often you receive those compound interest payments.
APY = (1 + Periodic Interest Rate) ^ Number of periods in the year – 1
Note (for the math gurus!): We see that there is indeed a link between the formulas for calculating the APR and the APY. If interest is paid annually, There is no room for interest to be generated during the year. This means that over a one-year period, they act like simple interests. With these variables, the APY formula for an annual rate is equivalent to the APR formula, i.e. APY = (1 + Annual Interest Rate)^1 – 1 = Annual Interest Rate = APR.
APR vs APY – What are the Differences?
The primary difference between APR and APY is the calculation of simple or compound interest. In the case of compound interest, the interest generated over a period is added to the basic capital, which in turn generates interest in subsequent periods.
Let’s take an example to illustrate the difference between APR and APY.
Take, for instance, you put your cryptocurrencies (see prices) in an interest-yielding crypto savings account. The interest rate offered by the platform is 1% per month. This indicates that your assets are invested at an APR of 12% (= 0.01 x 12).
If you place $1,000 of cryptos in this account, after one year you will have $1,120 (= 1,000 x [1 + 0.12]).
Let’s use the same example again, but this time let’s assume that the platform offers you an interest rate of 1% per month with compound interest paid each month.
In this case, your assets are placed at an APY rate of 12.68% (= [1 + 0.01]^12 – 1).
In the same vein, if you place $1,000 of cryptos in this account, after one year you will have $1,268 (= 1,000 x [1 + 0.1268]).
In What Contexts are APR and APY used in Crypto?
APR and APY are both used in crypto in the context of lending or staking. This is why it is crucial to know whether the return is in APR or APY before investing in these crypto products. If you decide to invest in the lending pool of a DeFi protocol, that is, if you agree to lock in some crypto over a certain period, you will be dealing with APR. For instance, let’s say you invest 1 ETH in a lending pool that has an APR of 24%. After one year, your capital will be 1.24 ETH, which is your initial investment of 1 ETH plus an additional interest of 0.24 ETH.
APY rates are often applied to cryptocurrency staking and investments in DEX liquidity pools (LPs).
What to Choose Between APR and APY?
The first important element when it comes to APR vs APY is to understand the differences between both rates when choosing your crypto products. Having a clear understanding allows you to compare offers more effectively.
So, which one is better: APR or APY? Ultimately, the answer depends on the type of crypto product you are considering. Typically, staking offers come with APY rates. In such cases, an investor would be inclined to go for the offer with the highest APY, as it will translate to the most return on investment.
Crypto loans, on the other hand, focus more on the APR rate. Here, the borrower will most likely go for the loan with the lowest APR to pay as little interest as possible. Be careful though, there might be compound interest on the offer. Calculate the APY (explained earlier in the guide) to find the actual interest, which could be higher than the APR.
Conclusion – APR vs. APY
When it comes to crypto investments, understanding the distinction between APR and APY rates is crucial to calculating the exact interest and return. Unlike the APR, the interest on an APY takes into account previously earned interest that is added to your principal amount. In the cryptocurrency market, especially with staking solutions, APY rates play a significant role. For investors looking to earn a higher income, APY is the more attractive option. Could this be an opportunity for you to earn passive income through staking with APY rates?