As you evaluate a potential investment, ROI is one of the first questions which spring to mind. It’s natural to want to get the most out of your investments! APR and APY are two terms used to calculate interest on investments and debts. Both sound similar, but are calculated differently. Let’s learn about them!
Before we dive deeper into APR and APY, let’s revisit a concept from middle-school mathematics. There are two ways to calculate interest on an amount:
- Simple interest, which only takes the principal into account.
- Compound interest, which factors in interest you have already earned.
What is APR?
Annual Percentage Rate, as the name suggests, is the rate of interest applied on an amount per year.
APR tells you how much interest you’ll receive at the end of the year on the amount invested. In terms of loans, APR will tell you how much interest accrued to the amount you borrowed over a year.
Say you invested ₹100 with an APR of 10%, you would receive ₹110 at the end of the year. This is correct when the interest is not compounded or the interest is calculated on the invested amount and given only on the invested amount.
But, what if the interest amount is credited to the invested amount monthly and eligible for earning interest from the next month? That’s where compound interest comes into play and APY helps to get an accurate number.
What is APY?
Annual Percentage Yield is the amount or the percentage rate of interest including the compound interest on an amount. Since APY calculates all the compound interest and the frequency of it, this is also called the absolute interest rate.
APY tells you exactly how much you receive (or need to pay in terms of loans) in a year.
For example, if you invest ₹100 with an APY of 10% which compounds monthly, you’ll receive ₹110.471306 at the end of the year. This is higher than Rs. 110 you’ll get with a 10% APR.
While APR tells you the rate of interest over a period, APY includes the compounded interest into the formulae. For the same reason, APY will be higher in most cases.
Okay, so how do APR and APY help with DeFi?
When it comes to DeFi, you’ll find variable APYs and APRs adjusted to account for many factors like the volatility of price, liquidity etc.
Here’s a great example of AAVE.com:
As decentralized financial systems mature, they have introduced APR and APY to incentivize users to visit their platforms. You’ll typically see these terms commonly used in services like staking and liquidity pools. These are systems where users lock their crypto tokens over a period and earn interest over their crypto assets.