APY and APR: Do You Know The Difference?
|— DeFi offers an alternative to traditional banking with potential advantages, higher returns and new offerings – but it can be a volatile environment, so understanding how to assess opportunities is essential.|
— APR and APY are terms that apply both to DeFi and the tradfi space, and give key information for speculators – but they can be confusing.
— APY takes into account compounding frequency, but APR does not, which makes a big difference to your return – understanding how to interpret each one is essential.
— Here, we explain these two key concepts, and how to assess the accompanying risks, so you can understand opportunities for yourself.
APY and APR come from traditional finance – but they are also essential knowledge for anyone using DeFi!
Whether you’re lending, borrowing or growing your savings account, finance has one common theme – we’re all aiming to have a little more. In times gone by, this meant a trip to the bank, a new file full of paperwork and likely, a nice profit for the bank itself.
But blockchain changed that. By providing a trustless system, where transactions could be guaranteed without any middleman, leaving in place an ecosystem where just about anyone can access a new array of options without even leaving their home. DeFi’s accessibility is what makes it so revolutionary.
Two of the most important – and confusing – terms you’ll see in DeFi are APY and APR. These two acronyms are used so interchangeably that many people aren’t even aware that they are, in fact, two different things. Both Annual Percentage Rate (APR) and Annual Percentage Yield (APY) measure how much interest you earn from your deposits, but they do so in different ways.
Here we will explore how knowing the difference can help you better understand and calculate potential – and risk – across traditional and decentralized finance.
DeFi Passive Income Options
One of the most attractive aspects of decentralized finance is the opportunities it offers for making passive income on your crypto. Yield farming via liquidity pools and staking are two of the most common ways to generate passive income in the DeFi space.
These options offer high returns, but they also pose a higher risk environment than traditional finance: a lot can happen while your cryptocurrency is locked up, so being aware of the risks you might face is key to choosing wisely. Luckily, the financial system has a sort of clever short-hand that allows you to assess opportunities at a glance; this takes the form of APY and APR, and here, we’ll show you how to interpret these.
What are APY and APR?
In basic terms, APY and APR are metrics that express the returns on your investment, and you’ll see them a lot in DeFi. But they are not the same – so in order to make an informed assessment of the opportunities available to you (and understand the risk the figures are expressing), you’ll need to understand exactly how each one is calculated. Let’s deal with APR first.
APR (Annual Percentage Rate) is a common measurement used by banks when presenting loan options to clients,cand you’ll also find it in DeFi.
APR is the interest rate you’ll earn per year on your sum. The defining feature of this measure is how that interest is calculated: it’s a function of the principal sum only, and does not take into account interest already earned on the same sum. Let’s show that using an example.
Say you make your crypto (equal in value to 10,000 USD) available for a loan for three years, and it has a return of 5% APR.
Each year, you will make a return of 5% of the original sum loaned – in this case, 500 USD. So by the end of a three-year investment, you will have made 1500 USD, and you’ll also have your original sum back too.
APY (Annual Percentage Yield) is the interest rate that you receive on an investment when both the principal sum and the interest on that sum are compounded.
Let’s look at an example. Say you make an investment of 10,000 USD for three years and it has a return of 5% APY. The compounding period – the frequency at which the interest is recalculated – is every 12 months.
Each 12 months, you’ll make 5% interest on both the original sum paid and the interest itself.
Year 1: 5% of 10,000 = 500.00
Year 2: 5% of 10,500 = 525.00
Year 3: 5% of 11,025 = 551.25
Here, for the exact same sum and interest rate, you would have made 1576.25 USD in yield. This is because the calculation included both the principal sum and the interest accruing on that sum. Therefore, APY assumes through its calculation that you will deposit both your principal sum AND the yield on it back into the same protocol at the end of the compounding period.
The result? The reward is attractive BUT assumes a greater degree of commitment to the project on your part, and this is something that needs to be borne in mind.
Risks Associated with DeFi Passive Income
DeFi presents unprecedented freedom – and to an extent, unprecedented rewards – for users. But it also comes with risks: liquidity pool users may stand to make substantial rewards, but their locked liquidity may be subject to impermanent loss among other things. And in an ecosystem where projects are free to launch without scrutiny, some projects are clever vehicles for rugpulls, where developers accumulate crypto from hopeful users and then abandon the project.
Doing your own research is key to your success – the good news is that most of what you need is right at your fingertips.
How to Do Your Own Research (DYOR)
Beyond checking the returns offered by a given DeFi project, there are other resources you can refer to in order to build a picture of the project you’re interacting with.
The white paper is basically a detailed roadmap for a given project, and explains its technology, application and vision for the future. Here, you can get a good sense of where a project is going, and what it offers to the market.
Another great resource is Etherscan, where you can gather information about the protocol’s prior activity, and how its tokens are distributed – key information in deciding whether the project is genuine. Check out how that works here.
And finally, Discord is also a valuable resource for anyone looking for information on an eye-catching project. Here, you can build a picture of how engaged the community and the devs themselves are and whether the creators are happy to answer questions, all of which can help you understand who you’re interacting with.
Get free, get learning!
The freedom of DeFi means it’s more important than ever to understand key metrics and risks. Instead of focusing on getting the highest yields possible, it’s better to make sure you understand the risks, and what you can do to minimize them.
Luckily, you have Ledger Academy! We’re here to explain key concepts, risks and the tools you can use to figure out the crypto space for yourself. And if that’s not enough, we’re also busy integrating a host of DeFi platforms within the secure gateway of Ledger Live, helping you to interact securely with the space. Check out what that means for you right here!
Knowledge is power, so keep learning as you explore these new possibilities – securely – with Ledger.
Knowledge is power.
Passive income is one of DeFi’s big triumphs – and it’s worth learning about! Here, School of Block gives you the lowdown, so you make your crypto work for you!