Summary

You've probably come across these two related terms: annual yield (APY) and annual percentage rate (APR), when browsing through decentralized finance (DeFi) products.

Annual Percentage Rate (APY) is interest that is compounded quarterly, monthly, weekly, or daily, while Annual Percentage Rate (APR) is not compounded. This small difference can make a big difference in your return calculations over a period of time. So it's important to understand how these two rates are calculated and how they affect the returns you can earn from your digital money.

Annual return versus annual percentage rate

Annual percentage rate and annual yield are both essential for the purposes of personal finance products. Let's start first with the simpler term, annual percentage rate (APR). It is the interest rate that a lender earns on its money — and that a borrower pays for using it — over the course of one year.

For example, if you put $10,000 in a bank savings account with an annual interest rate of 20%, you will earn $2,000 in interest after one year. Your interest is calculated by multiplying the principal amount ($10,000) by the annual percentage rate (20%). So, after one year you will have a total of $12,000. After two years, your capital will reach $14,000. After three years, you will have $16,000, and so on.

Before we get into annual yield (APY), let's first understand what compound interest is. It simply means earning interest on past interest. In the example above, if the financial institution pays monthly interest to your account, your balance will look different each month throughout the year.

Instead of receiving $12,000 at the end of the year, you will receive some interest every month. This interest is added to the value of the basic amount you deposited, and the amount you receive increases as the months pass. Each month you will have more money accruing interest. This is called compounding or compound interest.

Let's say you deposit $10,000 into a bank account at a 20% annual interest rate with monthly cumulative interest. Without going into complex calculations, you will get $12,429 at the end of one year. This is an increase in interest earned of $429 simply by adding the compound interest factor. How much interest would you earn with an annual percentage rate of 20% but with daily compounding interest? This will give you $12,452.

The effect of compounding interest is much greater over longer periods. After three years, you would end up with $19,309 of the same 20% annual rate through daily interest compounding. This means an increase in interest earned of $3,309 more than the interest earned from the 20% annual percentage rate without doubling interest.

Once you add compound interest, you will earn a lot more interest on your money. Also note that interest varies depending on the frequency of doubling, as you can earn more the more frequently you doubling. Daily doubling gives you greater benefit than monthly doubling.

How do you calculate how much you can earn when a financial product offers compound interest? This is where the Annual Yield (APY) comes into play. You can use a mathematical formula to convert the annual percentage rate to the annual return based on the compounding frequency. An annual percentage rate of 20% with a monthly compounding equates to a 21.94% annual return. In the case of daily doubling, it will equal 22.13% of the annual return. These numbers represent the annual interest rates you earn after adding compound interest.

In short, the Annual Percentage Rate (APR) is a simpler and more stable metric: it is always stated as a fixed annual rate. But the annual return (APY) includes the interest earned on the interest, which is called interest compounding or compound interest, and changes depending on the frequency of interest compounding. One way to differentiate between them is to remember that the word "yield" is six letters long (two more than the word "rate") and this represents that it is a more complex concept (and yields greater gains).

How do different interest rates compare?

From the example above, you can see that more interest can be earned when the interest is doubled. Different products may offer their prices at either an annual percentage rate or an annual yield. Because of this discrepancy, it is necessary to use the same term for comparison. Be careful when comparing products, you may be comparing apples with oranges.

Products that offer a higher annual percentage rate will not necessarily yield more benefit than products with a lower annual percentage rate. You can easily convert the annual percentage rate and annual yield using online tools if you are aware of the compounding frequency.

This also applies to decentralized finance (DeFi) and other types of cryptocurrency products. When looking at ads for products that use an annual percentage rate and annual return like cryptocurrency savings and storage, be sure to convert them so you can compare apples to apples.

Furthermore, when comparing two DeFi products with annual returns, make sure they have the same compounding frequency. If they have the same annual percentage rate, but one compounds interest monthly and the other daily, a product with a daily compounding will earn you more cryptocurrency interest.

Another important point to note is to know what the annual return means for the cryptocurrency product you are previewing. Some products use the term “annual return” to refer to the rewards a user can earn in digital currency over a specified period of time, rather than the actual or expected return in any local currency. This is a point of difference to be aware of because digital asset prices can be volatile, and the value of your investment (in local currencies) may fall or rise. If digital asset prices decline significantly, the value of your investment (in local currencies) may still be less than the original amount you invested, even if you continue to earn an annual return on the digital assets. It is therefore important that you carefully review the terms and conditions of the relevant product, and conduct your own research to fully understand the investment risks and what “annual return” means in this specific context.

Concluding thoughts

You may feel confused between annual percentage rate and annual yield at first, but it's easy to differentiate between them by remembering that annual percentage yield (APY) is the more complex metric that involves compound interest. Due to the effect of compounding interest on interest, the annual return is always higher when interest is compounded more frequently than once a year. The bottom line is that you should always check the rate you are looking at when calculating the interest you will earn.

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