WhaleVest | WhaleVest 100 Compass | What is the difference between APY vs APR?

APR vs. APY

Both APR and APY are quite important for personal financial purposes. Let's start with a simpler term, Annual Percentage Rate (APR). This is the interest rate that lenders earn on their funds over the course of a year—and the interest rate that borrowers pay for the use of that funds.

For example, if you deposit $10,000 into a bank savings account at 20% APR, you'll earn $2,000 in interest after one year. Your interest is calculated by multiplying the principal amount ($10,000) by the APR (20%). Therefore, the total amount you will have after one year is $12,000. After two years, your principal will be $14,000. After three years, you'll have $16,000, and so on.

Before we discuss annualized yield (APY), let’s understand what compound interest is. Simply put, it means earning interest on previous interest. In the example above, if the financial institution pays interest on your account each month, your balance will differ throughout the twelve months of the year.​

Instead of getting $12,000 at the end of month 12, you'll earn some interest each month. This interest is added to the principal of your deposit, and the total interest you earn increases over time. Each month, you'll have more money to earn interest on. This effect is called compound interest.​

Let's say you deposit $10,000 into a bank account at 20% APR, compounded monthly. Without complicated math involved, you'll end up with $12,429 at the end of the year. This equates to an additional $429 in interest earned just through the added effect of compounding. But how much interest can you earn on that 20% APR if you use daily compounding? Your total principal will be $12,452.​

The longer the time span, the greater the power of compound interest. After three years, you could end up with $19,309 compounded daily on the same 20% APR product. That's $3,309 more in interest than the same 20% APR product without compounding.​

By using compound interest, you will earn more money on your principal. Also note that interest will vary based on how often it compounds.When compound interest occurs more frequently, you earn more. The interest compounded daily will be higher than the interest you will earn compounded monthly.​

How do you calculate how much money you can make when a financial product offers compound interest? This is where annualized yield (APY) comes in handy. You can use a formula to convert APR to APY, depending on how often interest compounds. 20% APR compounded monthly equals 21.94% APY. If compounded daily, it would equal an APY of 22.13%. These APY numbers represent the annualized interest earnings you earn after factoring in compound interest.​

All in all, APR (annual percentage rate) is a simpler, more static metric: it's always a fixed annual rate. But APY (Annualized Percentage Yield) includes interest earned through interest or compound interest. It will vary based on the frequency of compounding. One way to remember this difference is to remember that "yield" has five letters (one more than "rate") and represents a more complex concept (and higher yield).

How do you compare different interest rates?​

From the example above, you can see that more interest can be earned when the interest is compounded. Different products may display their interest rates as APR or APY. Because of this difference, the same conditions must be used for comparison. Be careful when comparing products as your baseline for comparison may not be consistent.​

A product with a higher APY will not necessarily generate more interest than a product with a lower APR. If you know how often interest is compounded, you can easily convert APR and APY using online tools.​

The same is true for DeFi and other types of cryptocurrency products. When looking at products advertised in cryptocurrency APY and APR – such as cryptocurrency savings and staking – be sure to convert first so that the baseline for comparison is consistent.​

Additionally, when comparing two DeFi products, confirm that their compounding periods are the same. If they have the same APR, but one is compounded monthly and the other is compounded daily, the one with daily compounding can earn you more cryptocurrency interest.

Another important point to note is how APY relates to the specific cryptocurrency product you are reviewing. Some product collateral use the term "APY" to refer to the rewards that can be earned in cryptocurrency over the selected time frame, rather than any actual or predicted rewards/yields denominated in fiat currencies.

This is an important distinction because cryptocurrency asset prices can fluctuate, and the value of your investment (in fiat currency) can fall as well as rise. If the price of a cryptocurrency asset drops significantly, the value of your investment (in fiat currency) may still be less than the original fiat currency amount you invested, even if you continue to earn APY on your cryptocurrency assets.

Therefore, it is important that you read the relevant product terms carefully and do your own research to fully understand the investment risks involved and what the APY means in particular circumstances.                               

Summarize

APR and APY may be confused at first, but it's easy to tell the difference as long as you remember that annualized yield (APY) is a complex metric that includes compound interest. Due to the effect of earning interest through interest, APY will be higher when compounding occurs more frequently than once a year. The principle is to remember to check which interest rate you are using when calculating the interest you can earn.​​