Cryptocurrency lending is a function of Decentralized Finance (DeFi), in which investors lend digital assets to borrowers in exchange for payments with interest. The most used interest rates in the crypto world are APR and APY.
So, let’s know below the meaning of these types of interest in crypto and the best use for each.
APR and APY meaning
What is APR?
The main difference between APR and APY is their complexity. Therefore, we can affirm that the APY (Annual Percentage Yield) is compound interest, while the APR (Annual Percentage Rate) isn’t.
If you have a bank account, then you are familiar with the interest rate paid by traditional banks. APR is an annual rate generally used by financial institutions.
To calculate a simple interest rate APR, let’s use a yearly interest rate of 10% on a $200 investment as an example. So, you will receive a $20 profit one year after you make your investment.
If you want to withdraw the earnings from your investering before the year ends, the profits will depend on your invested time. Thus, if half a year has passed, you will receive only half of the interest, that is, $10.
Though, if it’s the case that you are borrowing $200 at the same interest rate, after a year, you will have to repay the amount received plus $20.
The concepts of APR and APY are simple. Let’s start with the basic formula to calculate the APR:
APR = [P × (1 + R×T)]
The meaning of the letters in the formula is:
T — time in years
P — principal (the starting investment or loan amount)
R — interest rate used
Based on this formula, if you invest 12 DAI in a lending pool with an interest rate of 25%, your investment after one year will increase to 15. Therefore, applying the above formula would be: 13*(1+ 0.25*1) = 16.25 DAI.
What is APY in crypto?
APR and APY differ in the actual rate of return on investment. Thus, APY is a compound interest rate in which the investor receives interest on the interest, not only on the initial amount.
But, that the interest is compound does not mean that it is very complicated to calculate. On the contrary, the APR and APY formulas are straightforward to apply.
Therefore, since compound interest takes into account the accumulation of funds, the formula is as follows:
APY = [P (1 + R/N)N]
Where
P — principal (the starting investment or loan amount)
R — interest rate used
N — number of compounding periods
The attractive thing about APY is that the interest can be compounded in any set period and can be continuous, yearly, weekly, monthly, or annual. Also, it includes periodic recalculations that are not contemplated in the APR.
Hence, if we apply the APY formula with an interest rate of 25% to an investment of 13 DAI that, besides, has two recalculation periods, one at six and another at 12 months, then:
APY = [13(1+0.25/2)2]= 16.45319
You should also keep in mind that if you invest in cryptocurrencies with high levels of volatility (such as Bitcoin), the APY may vary depending on the markt.
In this sense, if the BTC’s price increases in the year and you have an investment with APY of the cryptocurrency, then the value of your deposit will also increase in USD. But if BTC prices decrease, you will also have less money in USD.
What is the difference between APR and APY?
As you can see, an investment for the same amount can generate more income in the same period if it is APY instead of APR. This means that if you borrow money, you should do it using APR interest. Likewise, if you invest, APY will always give a higher final amount.
However, capitalization is significant when investing or borrowing money with APY in crypto. Thus, you should pay close attention to how many times and how often the funds will be compounded.
APR and APY Which is Better?
Most DeFi platforms have APR and APY products used in liquidity pools, uitzetten services, loans, and yield farms.
However, some apply variable and not fixed interest rates concerning the initial investment or loan.
Fixed APR or APY rates remain stable for your investment, while variable rates may fluctuate based on crypto market conditions.
Another element to consider is the underlying fees of the blockchain where the investment is being made. Thus, transaction fees and gas (with tokens running on the Ethereum network, for example) can significantly lower an investment in crypto that applies high APR or APY.
Cryptocurrencies and decentralized finance open up new opportunities for all types of investors. However, it would help if you kept in mind that although crypto offers much higher interest rates and considerably more good earnings, the risk levels are higher.
For this reason, you should seek appropriate direction from your trusted financial advisor and evaluate which one best suits your needs between the APR and APY interest rates.
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