Are you the one who forgets to remember the difference between APY & APR? Or, If you are someone who thinks both are the same, then this blog is the best thing you will read today.
The crypto world has evolved more than the simple buying and selling of cryptos. Today, it offers you multiple options to earn crypto, allows you to take a loan, lend cryptos in a decentralized manner and much more. And, the two terms that are often used in DeFi are APR & APY. Let us understand what is their meaning, how they are used and what’s the difference between the two.
APR or Annual Percentage Rate is the interest paid by a borrower over a year. In general, APR is used when lending or borrowing money is involved. APR works on the principle of simple interest where the interest is charged on a yearly basis.
In the crypto space, APR is commonly used to represent the cost of borrowing assets on lending platforms such as Aave, Compound, and MakerDAO. Borrowers must repay the principal amount borrowed plus the interest accrued over the loan term. The APR gives borrowers a clear indication of the costs associated with their loans, making it easier to compare different borrowing options.
Calculating APR in crypto is relatively straightforward, as it involves dividing the total interest paid on the loan by the principal amount and multiplying it by the number of periods in a year. The formula for APR is:
APR = (Total Interest Paid / Principal) x Number of Periods in a Year
Assume: You borrow $1000 from a lending platform at a 15% APR for a year. Since your interest rate is calculated using APR, your interest for the year will be $150 and you will pay $1150 at the total fund at the end of the year.
Important: The same interest could have been more if your interest rate would have been calculated using APY instead of APR. This is because APY accounts for compound interest in the calculation of interest.
Annual Percentage Yield (APY) is a percentage that represents the total amount of interest earned or paid on an investment or loan in a year, taking into account the effect of compounding. Compounding refers to the process where interest earned is reinvested, allowing it to earn additional interest. APY provides a more accurate representation of the return or cost of an investment compared to APR, as it accounts for the frequency of compounding.
In the context of cryptocurrencies and DeFi, APY is often used to describe the returns on investments in yield farming, liquidity pools, and staking. Due to the highly dynamic nature of the crypto market, APY can vary significantly over time. Investors and borrowers need to consider both the potential returns and risks associated with different DeFi platforms and protocols to make informed decisions.
To calculate APY in crypto, you need to know the interest rate, the frequency of compounding, and the duration of the investment. The formula tells you what will be your APY if the same principal amount, time period and interest rate are followed as of APR.
APY = (1 + r/n)^(nt) - 1
r = nominal interest rate
n = number of compounding periods per year
t = time in years
By using this formula, you can determine the APY for various DeFi platforms and compare them accordingly.
To understand the effect of compounding, let us take the same example we used for the calculation of APR.
Assume, you invested $1000 for a period of 1 year at an APR of 15% but here your interest is compounded monthly. So, for the first month, you will receive $1012.50 at an interest of 1.25%. For the second month, instead of $1000, your returns will be calculated at $1012.50 and you will receive $1025 and so on for the rest of the year.
At the end of the year, you will earn $1163.85 which is higher than the $1150 that you would have earned with APR. And, you earned $1163.85 at an APY of 16.08%.
In the above example, if the same interest was compounded daily instead of monthly. Then you would have earned $1,174.71 at the end of the year at an APY of 17.47%. In APY, the higher the frequency of compounding, the higher will be your earning at the end of the investment period.
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The major difference between the APY & APY is the way both calculate the rate of interest. Some of the major differences are:
Since APR represents a lower rate of interest, it is dominantly used to show the interest rate during borrowing or drawing a loan. To generalize, at all places where a user has to pay the interest rate from his pocket, APR is used in all those places.
Since APY represents interest calculated along with the compound interest, it is used to represent returns on yield farming, staking, and liquidity provision in DeFi platforms. To generalize, APY is used in all such places where a user is receiving interest in any form.
To state which one is better, APY & APR will be an unfair comparison as both have their own use cases. Rather, understanding them through different perspectives may help you to make informed decisions.
As a user, we are often drawn towards lower interest rates when borrowing and higher earn rates when using features like Yield, Staking or other types of earn.
This is why when a lender or business is advertising a loan they are offering it will always be represented in APR since it represents the lower interest rate. This helps them in attracting more users. Similarly, when advertising a feature like Staking, or Yield Farming, the interest earned by the user is always represented with APY since it represents a higher interest rate and helps in attracting users.
Therefore, when you are borrowing crypto it will be beneficial for you to look at the APR rates and when you are investing your crypto to seek high returns, looking at APY will be in your favor. But remember, APY is also as good as the number of times it is compounded in a year.
Okto is a multichain DeFi app where you can earn cryptos through investing in Liquidity pools, where you have to invest two different cryptos into equal amounts to earn rewards. Or, you can invest any token and earn interest on it. Since both of these options reward users, APY calculation is used.
You can explore different earning opportunities and compare different APY offered on Okto with the simplest user interface and security which uses MPC technology.
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Understanding the differences between APY and APR is crucial for anyone involved in the crypto and DeFi space. These metrics provide valuable insights into potential returns on investments and borrowing costs, enabling you to make informed decisions when participating in various DeFi platforms and protocols. By carefully considering APY and APR, you can optimize your investment strategies and borrowing decisions, making the most out of the opportunities presented in the ever-evolving world of blockchain and cryptocurrencies.