Annual percentage rate (APR) and annual percentage yield (APY) are important terms used in calculating interest on cryptocurrency investments or loans. Such investments may include staking, providing funds for liquidity pools, cryptocurrency accounts and more.
While some of these investments calculate interest based on APR, others use the APY method to calculate your interest payment. Consequently, every cryptocurrency investor needs to know the difference between the two terms. You may ask – why? To collect as much interest as possible and earn as much as possible!
Annual percentage rate (APR) – what is it, and how do you calculate it?
Everyone has certainly heard of the annual percentage rate. It is paid when using savings accounts or charged by traditional banks for loans. Talking about traditional finance: If the annual interest rate is 5%, then if we invest 100 PLN, we will get exactly 5 PLN profit after one year of saving. For a loan at the same interest rate we have to pay back 105 PLN to the bank.
In cryptocurrency, we calculate APR in the same way. The APR in cryptocurrencies refers to the simplest interest applied to the principal amount of an investment or loan. If you have held an investment or loan for less than a year, interest is calculated in proportion to the time you have held the investment. For example, a six-month investment at 5% will give you exactly half that, a return of 2.5% on the principal.
So how do you calculate the APR (APR)?
Use a simple formula: A=[P x (1 + R x T)] where:
A indicates the total final amount. P, is the initial capital. R – the rate of interest,
T – as the term in physics – the time.
You can understand this better with an example. We invest 2.0 Ether in the DeFi liquidity pool. The APR is 25%. We close our investment for exactly one year, i.e. 365 days. We put our data into the formula:
2.0 Ether (1 + 0.25 x 1)= 2.25 Ether. This is how much your annual interest will be.
You can understand this better with an example. We invest 2.0 Ether in the DeFi liquidity pool. The APR is 25%. We close our investment for exactly one year, i.e. 365 days. We put our data into the formula:
- Ether (1 + 0.25 x 1)= 2.25 Ether. This is how much your annual interest will be.
Annual percentage yield (APY) – definition and calculation methods
APY, or annual percentage yield. This is the interest on an investment or loan, with the difference that it is compound or compound interest. Interest is compounded over any period of time – annually, weekly, monthly or daily. That alone should give you pause for thought – calculating APY is more complex. Here we have to consider the number of periods in which this amount is adjusted based on the interest rate.
How do you calculate the APY?
As always – use the equation: A= [P (1 + R/N)N]
Where A is the total final amount. The letter P is the initial capital of the investment or loan. R is the interest rate we use and N is the number of compound interest periods.
And it is the N that is a crucial part of the formula for us. N distinguishes the APY from the APR. N is the number of periods or ‘number of times’ the investment amount is recalculated based on the nominal interest rate given.
Interest is added to the original investment amount at each of these recalculations. Accrued interest income must be added.
Example. We invest 1.0 Ether for one year. The APY rate is 24%. The investment has two payback periods – 6 and 12 months. The data is based on the following formula: [1.0 Ether x (1 + 0.24/2)2] = 1.2544 Ether. This is the amount of interest on your investment.
Differences between APR and APY
The only significant difference in the calculation of APR and APY is the compounding periods. For everything else – the investment, the interest rate or the investment period – it is the APY that will result in a higher final amount. What does this mean in practice? If you are lending money to someone, it is better to calculate the interest based on APR. If, on the other hand, you are the investor, the APY will give you a higher total return.
APR and APY are very common in DeFi protocols, centralized exchanges and cryptocurrency platforms in finance. Remember that compound interest can do wonders for cryptocurrency investments.
Summary
The investment and lending opportunities in the cryptocurrency industry are endless. Due to the nature of the cryptocurrency market, APRs and APYs are sometimes higher than in traditional financial markets. Therefore, the return opportunities are much higher, but also involve more risk.
However, before you decide to invest or borrow at these rates, make sure you know how they work.