Understanding the Critical Difference Between APR and APY in the Crypto World

In the crypto world, the terms you encounter while investing can sometimes be confusing. Two of these terms are APY and APR. These terms play a significant role in understanding how your returns are calculated and how they can impact your financial decisions. Being able to differentiate between APY and APR will help you make more informed investment choices. Let’s dive deep into these two terms and the differences between them.

What is APR (Annual Percentage Rate)?

APR, or Annual Percentage Rate, is a term commonly used in borrowing and saving transactions. This rate tells you how much interest you will pay when borrowing or earn when saving. However, APR does not include compound interest calculations; it is only based on the initial principal.

For example, let's say you invest $10,000 in a bank account with a 20% APR. At the end of one year, the interest you earn from this investment would be exactly $2,000, and your total amount would be $12,000. If you keep the investment for two years, your total would be $14,000, and after three years, it would reach $16,000. This calculation is based on simple interest, and the same interest rate is applied each year.

What is APY (Annual Percentage Yield)?

APY, or Annual Percentage Yield, expresses the return on an investment, including compound interest. This means the rate not only includes the return you earn on the interest but also the income gained by adding the earned interest back into the principal. Thanks to compound interest, the interest you earn gets added to your investment every month, leading to an increase in your total return.

For example, imagine you invest $10,000 in a bank account with a 20% APR, and the interest is compounded monthly. In this case, after one year, you would earn $12,194. If the interest is compounded daily, you would reach $12,213. This extra $194 shows the power of compound interest. After three years, with this interest, you could potentially earn $19,309. The power of compound interest creates a significant difference, especially for long-term investments.

Key Differences Between APR and APY

1. Interest Calculation Method

APR is a simple interest rate calculated based on the principal. It does not include compound interest. APY, on the other hand, includes compound interest, where the interest earned is added back to the principal to calculate future interest.

2. Growth of Earnings

With APR, your earnings are fixed annually, and you will receive the same amount of interest each year. APY, however, offers more returns each year because the interest is compounded. The more frequently the interest is compounded, the higher your earnings will be.

3. Example of Calculation

APR: With a 20% APR, a $10,000 investment would yield $12,000 at the end of the year.

APY: With the same rate but compounded monthly or daily, you could earn $12,194 or $12,213, respectively.

The Power of Compound Interest: Comparing APR and APY

When an investment includes compound interest, the interest earned is added back to the principal at the end of each period, which results in larger earnings over time. You can see how interest compounds by using formulas to convert APR to APY.

For example, a 20% APR investment, with monthly compound interest, turns into a 21.94% APY. If compounded daily, it turns into a 22.13% APY. This expresses how the frequency of compounding affects the additional earnings you will receive.

Things to Consider When Comparing APR and APY

Different financial products may use APR and APY rates, and comparing them without understanding the difference can be misleading. For instance, two products with the same APR might have different compounding frequencies, and the one with more frequent compounding will yield higher returns.

When evaluating DeFi products and crypto staking investments, ensure these terms are being compared correctly. In crypto investments, APY sometimes refers solely to the price movement of crypto assets, so the real value can fluctuate. Remember that the value of your investments can change over time, so it's essential to be aware of these fluctuations.

Conclusion: Using APY and APR Correctly

APR and APY may initially seem confusing, but understanding the basic differences is simple. APR is a simple interest rate and remains fixed, while APY includes the power of compound interest and provides more earnings over time.

When making investments, pay attention to which term is being used and always consider how the interest is calculated. This way, you can make more informed decisions in the crypto world and maximize the returns on your investments