Understanding the Difference Between APY and APR

When exploring decentralized finance (DeFi) products, you may have encountered the terms APY and APR. While these two terms might seem quite similar, they are in fact distinct.

Annual Percentage Yield (APY) incorporates quarterly, monthly, weekly, or daily compounding, whereas Annual Percentage Rate (APR) does not take compounding into account. This distinction, although simple, can significantly impact the calculation of gains over time. Therefore, it's crucial to understand how these two measures are calculated and how they affect the returns you derive from your digital funds.

APR and APY Explained

Both APR and APY are fundamental to personal finance. Let's start by introducing the relatively straightforward term Annual Percentage Rate (APR). APR is the interest rate a lender earns on their funds over a one-year period and is the interest rate a borrower pays to use those funds over a one-year period.

For instance, if you deposit $10,000 into a bank savings account with an APR of 20%, you would earn $2,000 in interest after one year. The interest is calculated as follows: principal ($10,000) multiplied by the APR (20%). Thus, after one year, your principal and interest would total $12,000. After two years, your principal and interest would be $14,000. After three years, your principal and interest would be $16,000, and so on.

Before introducing Annual Percentage Yield (APY), let's first understand compound interest. Simply put, compound interest refers to earning interest on previous interest. In the above example, if the financial institution paid interest on your account each month, your account balance would differ each month of the year.

Instead of receiving a lump sum of $12,000 at the end of the 12th month, you would receive interest each month. The interest received each month is added to your deposit principal, so the total amount you have to earn interest will increase each month. In other words, the principal you use to earn interest will grow month by month. This effect is called the compound interest effect.

Let's say you deposit $10,000 into a bank account at an annual rate of 20%, compounded monthly. Avoiding complex calculations, you would have $12,429 after one year. This means the compounding effect can help you earn an additional $429 in interest. Now, let's say you deposit $10,000 into a bank account at the same 20% APR, but with interest compounded daily. In this case, you would have $12,452 after one year.

The longer the interest period, the more astonishing the power of compound interest. Suppose you also deposit $10,000 into a bank account at a 20% APR, with interest compounded daily, but you extend the interest period from one year to three years, you would end up with $19,309. Compared to the 20% APR product that doesn't account for compound interest, this method can yield $3,309 more in interest.

Thanks to the compound interest effect, you can earn more with the same amount of money. Also note that the amount of interest varies depending on how frequently the interest is compounded. The more frequent the compounding, the more money you earn. For example, daily compounding can yield more interest than monthly compounding.

When a financial product offers compound interest, how do you calculate your yield? This is where Annual Percentage Yield (APY) comes in handy. You can use a formula to convert APR to APY based on the frequency of compounding. For example, a 20% APR compounded monthly equates to a 21.94% APY. The 20% APR compounded daily equates to a 22.13% APY. These APY figures represent the annualized yield of the interest rate you can earn after accounting for compound interest.

In summary, APR is a simpler and more static measure and is therefore always stated as a fixed annual interest rate. The annual yield APY includes interest earned on interest, which is compound interest. The amount of interest varies depending on the frequency of compounding. Here's how to remember the difference: the Y in APY stands for "yield," which is composed of five letters, compared to the R in APR, which stands for "rate." Moreover, compared to "rate," "yield" represents a more complex concept (yield is also relatively higher).

How to Compare Different Interest Rates

The above example shows that the effect of compound interest can generate more interest income. Different products may present their rates as APR or APY. Given this difference, when comparing different products, be sure to use the same terminology, otherwise they may not be comparable.

A product with a higher APY will not necessarily generate more interest than a product with a lower APR. If you know how often interest is compounded, you can easily convert APR and APY using online tools.

The same applies when comparing DeFi and other types of cryptocurrency products. When looking at products that may be advertised using cryptocurrency APYs and APRs (such as cryptocurrency savings and staking, etc.), make sure to convert them to the same term so they are comparable.

Additionally, if two DeFi products present yields in the form of APY, when comparing them, make sure they compound at the same frequency. This is because even if two products have the same APR, if one product is compounded monthly and the other daily, the daily compounded product can yield more interest in cryptocurrency.

Furthermore, you should be aware of what APY actually means in relation to the specific cryptocurrency product you're looking at. Some product guarantees use the term "APY" to represent the cryptocurrency rewards investors can earn in a specific time frame, rather than as actual or expected yield expressed in fiat currency. It's important that you carefully distinguish this important distinction, as cryptocurrency asset prices can fluctuate and the value of your investment (in fiat currency) may decrease or increase. If cryptocurrency asset prices decrease significantly, the value of your investment (in fiat currency) may still be lower than the initial amount of your fiat currency investment, even if you continue to earn APY in cryptocurrency assets. Therefore, you should carefully read the terms and conditions of the relevant product and conduct your own research to fully understand the investment risks involved in that product and what APY actually means in that specific scenario.

Summary

APR and APY can be easily confused at first, however, you can easily differentiate between the two simply by remembering that the Annual Percentage Yield (APY) measure takes into account compound interest and is more complex. Due to the compound interest effect of APY, when the frequency of compound interest is greater than once a year, APY is always higher than APR. Ultimately, when calculating the interest you will earn, always make sure to consider the correct interest rate.

Disclaimer and Risk Warning: The content of this article consists of facts and is intended for general information and educational purposes only and does not constitute any representation or warranty. This article should not be construed as financial advice and does not recommend that you purchase any specific product or service. For more information, please click here to read our full disclaimer. Digital asset prices can fluctuate. The value of your investment may go down as well as up and you may not get back the capital you invested. You are solely responsible for your own investment decisions and Gate is not responsible for any losses you may incur. Nothing above constitutes financial advice. For more information, please refer to our terms of use and risk warnings.