When exploring DeFi products, you may come across the terms APR and APY. The Annual Percentage Rate (APR) is the ordinary annual interest rate applied to the principal amount of an investment or loan, which does not include compound interest.
On the other hand, Annual Percentage Yield (APY) is a more complex metric that takes into account both the ordinary interest and any additional interest earned through compounding. The difference between these two metrics can have a major impact on the returns you can expect from your digital funds, so it's important to understand how they are calculated.
What are the differences between APR and APY when calculating interest?
APR is quite simple to understand. For instance, let's say you invest 1000 USDC into a DeFi lending pool with a 35% APR. After one year, you can expect to have an additional 350 USDC in interest on top of the initial 1000 USDC investment, bringing your total to 1350 USDC.
In order to calculate APY, we need to understand how compound interest works. Compound interest is earned on the interest from the previous period, so that your balance grows exponentially over time. The same 1000 USDC staked at 35% per annum with for example biannual compounding of interest over the first 6 months will yield you 1175 USDC, and after 12 months you will earn 1380,63 USDC. This extra 30,63 USDC is the result of compound interest, yielding an annualized percentage yield of 38.06%.
The power of compounding is even more remarkable when applied over a longer period of time. Additionally, the amount of interest earned can vary depending on the frequency of compounding. For instance, daily compounding will generate more interest than monthly compounding.
When you're comparing DeFi products, make sure you use the same term (either APR or APY) as the discrepancy can be significant. You can use online tools to convert APR to APY if you are aware of the compounding frequency.
In addition, when comparing 2 products based on their APY, it is essential to make sure that their compounding periods are equal. A product with a shorter compounding period, could potentially yield a higher rate of interest.
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Every investor needs a reliable way of comparing investment opportunities and calculating their profits. APY, or annual percentage yield, is a more comprehensive metric that takes compound interest into account and can result in higher earnings.
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