DeFi protocols use two metrics to represent returns of cryptocurrency investments (yield farming): Annual Percentage Rate (APR) and Annual Percentage Yield (APY).
But how do these work and why might this be important in the long run?
Table of Contents
What is Annual Percentage Rate (APR)?
Annual Percentage Rate, abbreviated APR, is the annual rate of return, expressed in percentages. Also called simple interest, this APR gives DeFi users a figure that can be easily compared to the rates of other protocols.
What is Annual Percentage Yield (APY)?
Annual Percentage Yield, abbreviated APY, is the annual compounded return, expressed in percentages. It is calculated by taking interest on the initial amount invested as well as on the interest accrued on this amount. In other words, one earns interest on interest.
What is the difference between APR and APY?
The difference between the two annual returns is that APY takes compounding interest into account while APR does not. Simply put, APY refers to the compounding effect. This means that acquired interest rates contribute to the calculation of the next interest rate.
Example
Imagine you have 10,000 USDT and want to invest them in DeFi. You have a choice between two DeFi protocols that will pay interest on a weekly basis.
Protocol A gives you 10% APR on staking USDT for one year.
Protocol B gives you 10% APY on staking USDT for one year.
How much do you earn after 1 year?
Protocol A – At the end of the year, you have a total of 11 000 USDT.
Protocol B – At the end of the year you have a total of 11 050.65 USDT.
The reason Protocol B is a better investment is because the APY is calculated on interest paid in previous periods. With protocol A, interests will be paid on the deposited amount.
How do we convert APY to daily interest?
Because the DeFi space changes extremely quickly, it is sometimes wiser to convert APR/APY into daily interest. This can be done easily using the following simple formula.
Formula
Daily interest:
= (Principal) × (Daily interest)
= (Principal) × (APY ÷ 365)
Example
Principal of $10,000 and APY of 10%
= (10 000) × (10% ÷ 365)
= (10 000) × (0,02739%)
= 2,739
The protocol which gives an annual interest rate of 10%, will pay a daily interest rate of 2,739 USDT on an investment of 10,000 USDT.
Need to knows
- Some DeFi protocols use the two terms APR & APY interchangeably.
- Most DeFi protocols use Annual Percentage Yield (APY) to represent returns.
- APYs can change depending on the demand or use of a protocol. Some protocols use a fixed APY.
- Hesitate when you encounter ‘unrealistic’ APYs (e.g. APY = +2000%). Questions such as; Is this sustainable? Is there a use case for this project? must be asked!
Conclusion
The Annual Percentage Yield (APY) takes into account the compounding effect or compound interest.This is in contrast to the Annual Percentage Rate (APR), which indicates the simple return on an investment where interest will be paid on the initial investment.