There is a risk of confusion between the Annual percentage rate (APR) and Annual percentage yield (APY). They have a similar tone, and both involve things that are interesting. However, use caution because they cannot be substituted for one another.
Having this distinction clear in your mind can help you better manage your finances and make you a more responsible borrower.
The annual percentage rate and the annual percentage yield have a few major differences.
Annual percentage rate (APR) in General
It usually refers to money that you borrow, such as via a loan or a credit card.
- Credit card
- Car loan, personal loan, home loan or student loan
- Credit line for personal use or a line of credit secured by one’s home
APR in Crypto
The annual percentage rate, or APR, is calculated by applying the standard interest rate to the whole principal value of an investment or loan.
Since the APR is an annualised rate, the interest on a loan or investment that is kept for a shorter period of time will be calculated using a prorated method.
For example, an investment with a six-month term and an annual percentage rate (APR) of 5% will only yield 2.5% of the principal amount.
The APR can be understood with little effort. Take, for instance, the placement of one ether (ETH) in a lending pool operating on a decentralised finance (DeFi) network as an example.
If the annual percentage rate (APR) is stated to be 24%, then 0.24 Ether should be gained in addition to the initial investment if it is kept in the pool for the precise duration of one year.
As a consequence of this, the value of the investment should now be 1.24 Ether, consisting of the initial 1.0 Ether deposit plus the interest payment of 0.24 Ether (calculated based on an annual percentage rate of 24%).
Annual percentage yield (APY) in General
- Account for savings
- Accounts on the money market
The annual percentage yield (APY) of a certificate of deposit (CD) can tell you how much interest your investment has the potential to earn in a given year. In general, the potential annual percentage yield (APY) of your investment will be greater the higher it is.
In addition to the interest rate, the annual percentage yield (APY) takes into account compound interest as well as the frequency with which compounding occurs throughout the year.
When you have interest that compounds, it means that you don’t just earn interest on what you’ve already deposited.
When comparing different deposit accounts, the annual percentage yield (APY) can be more helpful than the interest rate because it takes compounding into consideration.
Take, for instance, the scenario in which you are contrasting two deposit accounts, both of which offer the same interest rate. It’s possible that the one that compounds daily would earn you more interest than the one that compounds annually, according to the annual percentage yield (APY).
APY in Crypto
In contrast to the APR, which only takes into account simple interest, the APY takes into account both simple and compound interest. T
he amount of interest earned on both the interest and the principal investment is referred to as compound interest. Because of this, the APY offers a better return on investment than the APR does.
By staking their coins and engaging in yield farming in order to supply liquidity to liquidity pools, investors have the opportunity to earn an annual percentage yield (APY).
They can also receive an annual percentage yield (APY) if they keep their coins in savings accounts.
To begin earning an annual percentage yield (APY) on their Bitcoin holdings, investors may use crypto exchanges, crypto wallets, or DeFi protocols. It is common practice to pay interest in the same cryptocurrency that was initially invested; however, there are situations in which a different currency is used to pay interest.
The Differences Between APY and APR
The annual percentage yield is the amount of interest generated over a year, whereas the annual percentage rate is the amount of money that has to be paid out as interest over the course of a year.
When comparing the Annual Percentage Rate (APR) and the Annual Percentage Yield (APY) returns, the most important distinction lies in the application of compound interest. All other aspects, including the principal amount, the interest rate, and the length of time an investment is held, are identical.
It is a representation of the overall return, which takes into account both the interest and the principle generated on the investment. The Annual Percentage Yield (APY) always results in a greater total than the Annual Percentage Rate (APR), which does not take compound interest into account.
Investors in cryptocurrencies have the option to risk their coins, preserve their holdings in savings accounts, fund liquidity pools on exchanges, or invest in yield farms.
Knowing the difference between the annual percentage yield (APY) and the annual percentage rate (APR) is essential for deciding how to effectively invest one’s money.
Borrowers stand to benefit significantly from the use of APRs from a pragmatic standpoint. However, people who want to put money in the bank should take into consideration the annual percentage yield (APY) to get the most out of their investments.
Due to the proliferation of DeFi tools and cryptocurrencies that use APRs, investors need to engage in manual compounding, which requires them to reinvest their profits on a daily or weekly basis in order to obtain a more substantial compound interest rate.
Calculation of APR
With these two numbers, you can:
- First, calculate the loan’s fees and interest. Combine.
- Then divide by the loan principal.
- Divide step 2’s result by the loan’s days.
- 365 times step 3’s answer.
- Multiply step 4’s answer by 100 to get a percentage.
(Fees + Total Interest / Loan Amount) / Total Days) 365 × 100 = APR
$460/$3,900 principal = 0.11794872 0.11794872/200 days = 0.00058974
0.00058974 365 = 0.215 APR of 21.5%
Some borrowers benefit from knowing an APR. APR includes mortgage closing fees, so it’s a more accurate way to compare loans. When examining financing choices, consider both the APR and interest rate to see the full expenses of borrowing from a lender.
Calculation of APY
APY = (1 + r/n)n − 1
- The “r” represents the decimal representation of your interest rate.
- The value of “n” corresponds to the number of times your interest compounded over the course of a year.
For illustration’s sake, let’s pretend the investment has a monthly compounding rate and the interest rate is 0.05% each month.
APY = (1 + 0.0005/12)12 − 1
APY = 0.050011%
You should learn how to calculate APY because it is used in circumstances in which your investment is growing and you will need to use it. It will assist you in calculating how much money you are able to make over the course of a number of years.
Because APR is determined annually, it can be better for borrowers seeking the best rates than investing in crypto assets.
APY is more helpful for investing in crypto assets because it’s based on an annualised rate that incorporates compounding earnings. It gives a more accurate reflection of what will be made when money is invested and compound interest kicks in.
Investing or borrowing requires knowing if profits or payments are based on APR or APY. The crypto market has huge profits compared to regular finance, but also high risks.