According to the Consumer Financial Protection Bureau (CFPB), the APR or annual percentage rate is the amount paid to borrow money. It’s also known as a credit card interest rate and is generated yearly.
For instance, if the APR is 5%, a $100 investment will provide a $5 return a year later. In contrast, if $100 is borrowed at the same interest rate, the initial $100 loan plus $5 in interest must be repaid after a year.
Understanding APR provides an overview of how much will be owed when borrowing money or how much an investor will get paid. In the context of credit cards, APR is typically not charged when the card is used, but the balance is paid each month by the due date. However, if there is an outstanding balance and the due date passes, the interest is added at the end of each billing period.
In cryptocurrency, the APR is the percentage investors can expect to earn as interest on their investment, for lending their crypto or making it available for loans. It considers other fees a borrower needs to pay but does not include compound interest.
Essentially, the APR is the ordinary interest rate applied to the principal amount of an investment or loan. Since the APR is an annualized rate, prorated interest will be charged if an investment or loan is held for a shorter period. For instance, a six-month investment with a 5% APR will yield only 2.5% of the principal amount.
The APR is very straightforward. Take, for example, an investment of 1.0 Ether (ETH) in a lending pool on a decentralized finance (DeFi) network. If the expressed APR is 24%, then 0.24 Ether should be earned on top of the initial investment if it is locked in the pool for exactly one year. As a result, the investment should now total 1.24 Ether, made up of the 1.0 Ether principal and the accrued 0.24 Ether in interest (based on 24 % APR).
Here’s how to calculate the total final amount based on APR:
Following the earlier example, this would go as follows:
The calculation changes if the investment is retained for a shorter period. For example, holding for three months is equivalent to a quarter of a year (0.25), which means the calculation will be:
Holding for three months will earn only 1.06 Ether on top of the initial investment. Another formula to calculate APR is:
So, what does a 10% APR mean in crypto?
A 10% APR means 10% is earned on the initial investment after a year.
Using the above calculations, an investment of 10,000 coins at a 10% APR will accrue 1,000 coins in interest after a year.
The APY, short for Annual Percentage Yield, is a way to measure how much money can be earned on an interest-bearing account in a year. In crypto, the APY is the rate of return made on an investment.
Unlike the APR, which only considers ordinary interest, the APY includes compound interest. Compound interest is the amount earned on the interest and the principal investment. This is why the APY is more profitable than the APR.
Investors can earn an APY by staking their coins and using yield farming to supply liquidity to liquidity pools. They can also earn an APY from holding their coins in savings accounts.
Investors can use crypto exchanges, crypto wallets or DeFi protocols to start earning an APY on their Bitcoin. Interest is often paid in the same cryptocurrency invested; however, there are instances where a different currency is paid.
The compound interest can be set to daily, weekly, monthly, annually or continually.
Calculating the APY is a bit more complex than the APR since interest is added to the principal, and then the interest on that total is calculated, considering the number of periods the amount is adjusted.
To calculate the APY, you can use the following formula:
For example, an investment of 1,000 coins is made at a compound interest of 10% and daily compounding. The following calculation indicates that a total of 1,105 will be collected after one year. In the following year, it should be 1,221. The earnings increase the longer it is held and at higher interest rates.
Every time the computation is updated, the interest should be added to the sum comprising the initial investment and the accrued interest profits. But what does a 10% APY mean in crypto?
Most cryptocurrency projects offer only 1% APY, but some offer 7% on flexible accounts, such as Phemex for Tether (USDT). In the case of fixed saving accounts, they can go as high as 10%. There are also DeFi platforms like PancakeSwap (CAKE) and SushiSwap (SUSHI), which are said to offer very high APYs of over 100% to investors.
Both the APY and the APR are used to calculate interest for crypto investments and loans. However, they are not the same.
The annual percentage yield refers to the amount of interest earned over a year, while the annual percentage rate is the amount that needs to be paid as interest. When comparing the APR and APY returns, considering that all other factors such as the principal amount, interest rate and period of investment are the same, the key difference is the compound interest.
It represents the total return, including the amount earned on the interest and principal investment. Because the APR does not account for compound interest, the APY always yields a larger sum.
Crypto investors can fund liquidity pools on exchanges, keep crypto in savings accounts, stake their coins or invest in yield farms. The difference between the APY and the APR is crucial to understanding where money is best invested. Practically speaking, APRs are advantageous to borrowers. However, individuals wishing to invest funds should consider APY rates to maximize their profits.
Given that more DeFi tools and cryptocurrencies use APRs, investors have to do manual compounding, where they have to reinvest their gains, either daily or weekly, to get a more significant compound interest.
The APY provides a clear idea of an account’s earning potential. The APR shows what will be owed. Both are calculated over a single year, which provides a more accurate picture than calculating the interest rate alone.
Because the APR is calculated at an annual rate, it can be more advantageous for borrowers seeking the best rates, instead of investing in crypto assets and hoping for a return.
However, because the APY is based on an annualized rate that includes compounding earnings, it's more beneficial for investing crypto assets—it provides a more accurate representation of what will be earned when money is invested and compound interest kicks in.
Understanding whether profits or payments are based on an APR or an APY is crucial when investing or borrowing. Given the nature of the crypto market, returns are often high compared to the traditional finance sector but so, too, are the risks.
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