Understanding APR: The key difference between APR and APY in cryptocurrencies

If you are exploring the world of decentralized finance (DeFi), you have probably seen these two terms floating around constantly: APR and APY. Although they sound similar, they represent very different concepts that can significantly impact your earnings. Understanding what APR is and how it differs from APY is essential before depositing your funds in any crypto product.

What is the Effective Annual Rate (APR) really?

The Annual Percentage Rate, or APR for its English initials, is the most straightforward concept of the two. It is simply the percentage of interest you will earn on your investment over the course of a year, without any additional capitalization.

Let's imagine a practical scenario: you invest 10,000 USD in a savings platform with an APR of 20%. After one year, you will earn 2,000 USD in interest, reaching a total of 12,000 USD. It's linear math: initial capital multiplied by the fixed rate.

If you continued for another two years with the same dynamics, you would accumulate 14,000 USD after two years and 16,000 USD after three. The profit is predictable and constant, with no surprises.

The transformative factor: compound interest

This is where things get interesting. Compound interest means that your earnings generate additional earnings. Instead of receiving the entire reward at the end of the year, imagine that the platform credits you with interest monthly. Each month, that interest is added to your capital, and in the following month, you earn interest on the larger amount.

This growing effect is what turns the Annual Percentage Yield (APY) into a superior metric.

APY: When interest works for you

The APY incorporates the power of compound interest in its calculation. Let's take the same previous example: 10,000 USD with an APR of 20%, but now with monthly compounding.

Instead of the 12,000 USD you would receive with simple APR, you would get approximately 12,429 USD. That's an additional 429 USD without doing absolutely anything except allowing the interest to be reinvested.

What happens if the capitalization occurs daily instead of monthly? The amount grows to 12,452 USD, generating 23 USD more in profits just by changing the frequency.

The true impact is observed in the long term. With the same APR of 20% but daily compounding, after three years you would have not 16,000 USD, but 19,309 USD. That is a difference of 3,309 USD, approximately 20% more than you would have earned without compound interest.

Convert APR to APY: The Crucial Formula

You don't need to memorize complex equations. The important thing is to know that:

• An APR of 20% with monthly compounding is equivalent to an APY of 21.94%
• The same APR of 20% with daily compounding reaches an APY of 22.13%

This conversion reflects the actual annual returns you obtain after incorporating the effect of compound interest.

Comparing DeFi Products: Avoid Confusion

Here comes the most important practical advice: when comparing two cryptocurrency products, always make sure you are using the same metric.

A product with an APY of 22% is not directly comparable to another that shows an APR of 20%. You must convert one to the other to make a fair comparison. If both specify APY, check that they have the same capitalization frequency (daily, monthly, weekly).

If a product offers daily compounding with an APY of 22% and another offers monthly compounding with an APY of 21%, the former will generate more real gains over time.

What you need to know about APY in crypto products

Here is a critical nuance: when a DeFi platform promotes an APY on cryptocurrencies, it is expressing rewards in units of that digital asset, not in fiat currency.

This is crucial because cryptocurrency prices are volatile. You could earn a 50% APY on Bitcoin, but if the price of Bitcoin drops by 60%, your initial investment in dollars will have decreased despite the gains in terms of BTC.

Therefore, it is essential to carefully review the product terms, understand what that APY means exactly in your specific context, and assess the associated risks.

Executive Summary

In short, the difference between APR and APY is simple yet transformative:

• APR is the fixed and simple rate, without capitalization.
• APY includes the effect of compound interest, being higher when there is capitalization more than once a year.

When evaluating crypto savings products, staking, or DeFi platforms, always check what you are analyzing. Choose APY as your main metric, confirm the capitalization frequency, and remember that the volatility of cryptocurrencies affects your returns in terms of fiat value.

With this understanding, you will be better equipped to make informed decisions about where to invest your digital funds.