Traditional finance has set a lot of terms that appear in countless industries, the crypto industry being included. And if you’re not familiar with these traditional finance terms, it’s even harder to understand how to make good moves in the crypto market.
If you’re here, you probably wondered, “What is APY in crypto?” “What is APR?” or “What’s the number of compounding periods in finance?” right?
These may be just a few of the questions you may have about traditional finance terms that you’ve most likely seen in the crypto space, especially if you’ve interacted with well-known exchanges like Binance, which offers interest paid for staking your crypto, for example.
In this article, we’ll go through these previously mentioned terms, ensuring that you understand them better by the end of the article and know what they refer to when you interact with them again.
Let’s dive in!
What is APY in Crypto?
Annual Percentage Yield (APY) represents the total percentage of return an investor can expect to earn on their cryptocurrency holdings over a one-year period, taking into account compounding interest.
In simpler terms, it is a method that allows for monitoring the gradual accumulation of interest over a one-year period.
The gradual accumulation of interest on your funds is known as compounding interest.
Basically, compounding interest is when the interest earned on an investment is reinvested to earn additional interest over time. In this case, this type of interest is calculated on both the principal amount (the initial investment) and the accumulated interest, leading to significantly higher returns over the long run.
It’s important to note that compounding interest differs from simple interest, where interest is only calculated on the initial deposit amount.
While often linked with traditional savings accounts, APY (Annual Percentage Yield) is an essential metric for cryptocurrency savings programs and operates like traditional savings structures.
In crypto, there are a number of ways to earn APY, including:
- Staking – This involves locking up your cryptocurrency in a special account to support the network of a blockchain project. In return, you are rewarded with a portion of the transaction fees generated by the network.
- Decentralized Finance (DeFi) Protocols – These protocols offer various financial services, such as lending and borrowing, that allow you to earn interest on your cryptocurrency.
- Cryptocurrency Exchanges – Some exchanges offer interest-bearing accounts where you can deposit your cryptocurrency and earn APY.
How Does APY Work in Crypto?
To understand how APY works, let’s take an example.
Suppose you invest $100 in crypto savings accounts with an APY of 5% that compounds quarterly. This means you would have $105.09 at the end of the year. In comparison, if simple interest were applied, the balance would be $105.
In practical terms, this means the investment yields 5.095% interest annually due to quarterly compounding. While this rate isn’t remarkably high, if you were to leave the initial $100 for four years with quarterly compounding, it would grow to $121.99. Without compounding, the total would have been $120.
For a better understanding, check the calculation formula below.
How to Calculate APY in Crypto?
Moreover, when calculating APY for crypto investments, it’s essential to consider additional factors.
Inflation is a significant consideration; if the cryptocurrency you invest in experiences inflation rates higher than your APY, your earnings may deteriorate rapidly.
Monitoring supply and demand is also crucial, as crypto APY can fluctuate based on the demand and liquidity of a particular cryptocurrency.
The success of your investment depends not only on the interest rate but also on its ability to outpace external factors.
What is APR in Crypto?
Annual Percentage Rate (APR) in the context of crypto investments indicates the percentage of interest or rewards investors can anticipate earning on their investment by lending their crypto or making it available for loans.
Unlike APY, APR does not take into account compound interest but considers additional fees that borrowers might need to pay. Even so, many platforms encourage customers to stake their crypto assets by offering competitive APR, excluding the compounding factor.
Since it is an annualized rate, the interest is prorated accordingly if the investment or loan is held for a shorter duration. For instance, an 8-month investment with a 5% APR would yield only 3% of the principal amount.
Two primary types of loans offered by exchanges are fixed and flexible loans.
- Fixed lending resembles a bank Certificate of Deposit (CD) and requires users to lock their money for a specific period at a fixed interest rate, offering a higher return.
- Flexible lending operates similarly to a savings account, allowing users to withdraw their cryptocurrency at any time but with lower returns.
How Does APR Work in Crypto?
To understand APR and how it works, we will use an example similar to the one from the APY explanation.
Suppose you invest $100 in a crypto savings account with an APR of 5% and an APY. With an APR of 5%, you would earn $5 in interest for the year. This would bring your total balance to $105.
So, as you can see, there is an interest directly proportional to the money you initially invested.
For a better understanding, check the calculation formula below.
How to Calculate APR in Crypto?
APR considers not only the interest rates on investments but also any additional fees associated with lending or staking cryptocurrencies. These fees can include transaction fees, platform usage fees, or any other costs imposed by the lending platform or exchange.
Also, APR aims to attract investors by offering competitive interest rates or rewards on their cryptocurrency holdings. Platforms often compete to provide higher APR to entice users to choose their services over others. The competitive rates make the investment or staking opportunity more appealing to potential participants in the crypto ecosystem.
Simple Interest vs. Compound Interest
Until this part of the article, you’ve heard about simple interest and compound interest. However, some things may seem unclear to you, but don’t worry because we will talk about them now, and we will make you understand these two ways to figure out how much you earn on your investments.
Simple interest sticks to the original investment amount and doesn’t bother with any interest you’ve earned over time. It’s a fixed rate that doesn’t change as you calculate more interest.
Now, compound interest is more dynamic. It looks at both the original amount you put in and the interest you’ve earned. Every time you add interest, the next calculation is based on the new, higher total. This compound effect makes your investment grow faster than with simple interest.
Remember, when comparing investments, think about how often the interest gets added. If it happens more frequently, like every day or month, your investment might grow faster because you’re getting interest more often.
APY vs. APR: At-a-Glance Comparison
So, even though APY and APR differ in some way when you’re thinking about investing, it’s good to consider both APY and APR.
APR helps figure out the percentage you pay for interest and fees in a year, but it doesn’t consider compound interest.
Now, APY is crucial because it factors in compound interest, but it usually doesn’t include fees. To get a real return on your investment, you need to subtract those fees.
So, putting both APR and APY together gives you a more accurate idea of how valuable your investment really is.
Important Facts to Remember
In DeFi, Annual Percentage Rate (APY) and Annual Percentage Yield (APY) are sometimes used interchangeably. However, most DeFi protocols primarily use APY to showcase returns on investments.
APY figures can fluctuate based on how much a protocol is being used or its demand. Some platforms stick to a fixed APY.
Be cautious when you come across exceptionally high APYs (like APY = +1200%). It’s crucial to ask questions like, “Is this sustainable?” and “Does this project have a legitimate use case?” to assess the reliability of such figures.
APY vs. APR: Which is Better Related to Crypto Assets?
APY and APR are both important metrics to consider when making investment decisions in crypto. However, they measure different things and are better suited for different purposes.
When is APY Better than APR?
APY is a better measure of the total return on investment than APR, especially for investments with frequent compounding. This is because APY considers that interest is earned on both the principal and the interest earned in previous periods, which can lead to a significant increase in the total return over time.
When is APR Better than APY?
APR is a better measure of the total cost of borrowing money than APY, especially for long-term loans. This is because APR considers that interest is compounded over the entire life of the loan, which can lead to a significant increase in the total cost of the loan over time.
Which is Better for Crypto Investing?
Since crypto investing often involves holding assets for extended periods, APY is a better measure of the potential return on investment than APR.
What’s the Number of Compounding Periods in Finance?
The number of compounding periods in finance refers to how often interest is calculated and added to the principal amount within a specified time frame. Common periods include annually, semi-annually, quarterly, or monthly.
What to Do with Earned Interest?
Your earned interest contributes to your portfolio, generating passive income with minimal effort. You have options: reinvest the interest to earn more, use it for trading in the cryptocurrency market (spot or derivatives trading), or consider it a store of value, preserving its purchasing power for future use.
Should You Use an APY Crypto Calculator? But an APR Crypto Calculator?
Based on our analysis, we recommend calculating your APY or APR yourself and not using just any calculator you can find on the internet. From our tests, some of them do not calculate APY and APR well, especially if you have to take into account specific aspects (such as fees in the case of APR). If you still use a calculator for this, use those of the big exchanges.
So, guiding the crypto market requires an understanding of terms rooted in traditional finance. As you’ve explored the complexities of APY and APR, you’ve gained insights crucial for making informed decisions in the crypto space.
Now, whether you’re venturing into staking on platforms like Binance or delving into decentralized finance, understanding these financial concepts empowers you to optimize returns and minimize risks.
As you dive into your crypto ventures, may your decisions be guided by a clear understanding of these fundamental financial principles.