What is APR? What is APY? The difference between APR and APY in DeFi.
While relatively similar, APY is a more beneficial investment compared to APR due to compounding interest.
Hello everyone,
According to Bankrate, the average interest rate for savings accounts in the US is currently 0.01 - 0.05%. With such low rates for traditional savings, it's not surprising that people are seeking profits in the cryptocurrency space. After all, everyone wants to earn passive income.
When it comes to cryptocurrency profits, APR and APY are two commonly used terms in DeFi, particularly in farming, staking, lending, and other related protocols. However, not everyone distinguishes between these two concepts.
What are the differences between them? Why can't they be interchanged? Let's delve into what APR and APY mean in DeFi to understand how to increase profits and make appropriate investment choices.
I'm Neo — Admin — Community Manager of Optimus Finance and Growth Marketing of LECLE Vietnam.
1. APR and APY definition
1.1 What is APR?
APR (Annual Percentage Rate) refers to the annualized actual percentage of profit you receive from an investment, WITHOUT compounding. The essence of APR is a simple interest rate, so your profits directly depend on the initial investment amount.
1.2 What is APY?
APY (Annual Percentage Yield) is the annualized percentage of profit earned from an investment, calculated with compounding. It represents the actual percentage of profit you earn from an investment, including compound interest. Compound interest, in contrast to simple interest, allows investors to earn interest on their interest, adding to the total initial investment capital.
For example, in DeFi, you can earn rewards for staking and add them to the total amount staked to receive higher profits in the next round.
Currently, most DeFi tools and cryptocurrencies utilize APR, and if you want to incorporate compound interest, you will need to manually calculate the compounding. Many users reinvest their profits daily or weekly to achieve higher returns through this method.
2. The difference between APR and APY
The most significant difference between APR and APY lies in the impact of compounding. While APY refers to the expected annual profit earned from a deposit after factoring in compound interest, APR only considers the interest earned based on the initial capital.
To further understand, let's consider two examples of profit calculations based on APR and APY:
2.1. APR
Example: Let's say you stake $1,000 with an annual interest rate of 12% (APR = 12%) and incur no fees. After one year, you would receive a total of
1,000 × (1 + 12%) = $1,120
In the second year, you would receive $1,240. In the third year, it would be $1,360, and so on. Overall, your investment would steadily increase by approximately 12% each year compared to the initial capital.
In summary, with APR, you can calculate the expected profit you will receive at the end of the year.
2.2. APY
Assuming you stake $1,000 with an APY = 12% compounded semi-annually, the profit you would earn in the first 6 months can be calculated as follows:
1,000 × 0,12/2 = $60
In the next 6 months, in addition to the initial capital of $1,000, you will also have the accumulated interest of $60 from the previous 6 months. Therefore, the profit you would have at this point would be:
1,060 × 0,12/2 = $63.6
On the other hand, if you do not withdraw any funds within a year, your interest will be added to your balance weekly, and the interest paid will continue to compound throughout the year.
So, after one year, you would receive a total of $1,123.60.
The additional $3.60 comes from the power of compounding interest. Therefore, your actual annual percentage profit is 12.36%.
Compared to APR, APY is a more effective investment tool that can generate higher profits. It takes into account both the initial principal amount and the interest earned in previous periods.
As the interest compounds, the interest on the total balance increases over subsequent periods, leading to higher overall returns. This compounding effect makes APY a valuable metric for evaluating investment opportunities and maximizing profits.
3. The formulas for calculating APR and APY
3.1. APR
APR = [(Fee + Profit) / P] / n * 365 * 100
Where:
P - Initial investment amount
n - Number of days in the period
3.2. APY
APY = (1 + r/n)^n – 1
r: The annual interest rate as a decimal.
n: The number of compounding periods within a year.
4. Why is APY often high in the crypto market?
APY in the cryptocurrency market tends to be constantly changing. Therefore, the APY displayed on cryptocurrency exchanges, liquidity pools, and staking pools is often an estimate.
The fluctuations occur due to changes in the supply and demand dynamics of specific cryptocurrencies. If there is high demand for a particular cryptocurrency, interest rates and APYs tend to increase as well.
The blockchain protocol of projects also plays a role in calculating APY as the compounding period may vary for each project. The more compounding periods there are, the higher the APY tends to be. However, the difference is relatively small.
For example, if you deposit $100,000 into a liquidity pool with a 5% interest rate and calculate interest monthly, you would have approximately $105,116 after one year, corresponding to an APY of 5.116%.
If the account compounds interest daily, you would have around $105,126 after one year, equivalent to an APY of 5.126%.
The difference between monthly and daily APY is only about 0.01% - a negligible discrepancy.
Currently, most services offering high APY are yield farming or liquidity mining. Users provide liquidity to liquidity pools and lend their tokens to others to earn profits and rewards.
There are even projects that offer very high APYs exceeding 100%, often found on DeFi platforms like PancakeSwap (CAKE), Uniswap (UNI), and SushiSwap (SUSHI).
The APY rates on these platforms are highly competitive. If transaction fees are low enough, yield farmers can switch between liquidity pools on different platforms to maximize their income.
However, it is important to note that some scam projects may advertise high APYs to attract users, only to later withdraw liquidity and run away with investors' funds. Therefore, it is crucial to choose reputable and trustworthy platforms.
5. Considerations when calculating profits based on APY and APR
5.1. Compounding Period
Compound interest can be calculated on a daily, weekly, monthly, quarterly, or yearly basis, depending on the platform. Regular compounding can help you earn more profits. However, if the APY offered by the platform is less than 100%, the compounding effect may not be significant.
5.2. Transaction Fees
Not all platforms have the same fee structures, and the fees are not typically included in APR and APY calculations. However, it is important to carefully research and understand these fees as they can significantly impact your profits.
5.3. Exchange Rate Fluctuations
If you choose a fixed APY rate, the profits you receive will not change over time. However, in the DeFi space, APY often fluctuates and changes based on market conditions. Therefore, it's important to pay attention to the interest payment period and the periodic interest rate to understand your investment profits.
6. Closing thoughts
While relatively similar, APY is a more beneficial investment compared to APR due to compounding interest. Many users reinvest their profits daily or weekly to achieve higher average returns using this method.
As a cryptocurrency investor, having a good grasp of the concepts of APR and APY will enable you to easily compare different platforms or assets, thereby optimizing your profits.
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