Although they may seem similar at first glance, they represent different concepts. These notions are all the more important to know before using decentralized finance protocols (DeFi).
APR (Annual Percentage Rate) and APY (Annual Percentage Yield) are both commonly used metrics in DeFi (Decentralized Finance) protocols to calculate the interest rates on crypto assets. While they serve similar purposes, there are a few key differences between the two.
What is APR?
The Annual Percentage Rate (APR) is a rate that represents the total cost of a loan or credit to the borrower.
It includes simple interest and the annual yield, i.e., the percentage gain or loss on an initial investment, and the costs and charges associated with the transaction, such as transaction fees.
In the context of DeFi, APR measures the potential return users can earn by lending or borrowing their cryptocurrencies in protocols.
What is APY?
The Annual Percentage Yield (APY) expresses the annual return on an investment. It gives investors a precise idea of how their money has grown over one year.
The Annual Percentage Yield considers compound interest, which is accumulated over time, which we will explain in greater detail later in this article.
What are the differences between APR and APY?
APR and APY are, therefore, two measures used to assess financial costs and returns. However, there are some notable differences.
APR is used for loans and credits, reflecting the overall cost of borrowing, while APY is used on savings and investment accounts, as it leads to a higher overall return.
What’s more, unlike APR, which considers only the base rate and associated fees, APY considers not only interest rates but also the effects of compound interest and reinvestment over time, resulting in a higher return.
Let’s take the example of Alice holding 1000 USDC on Protocol A, offering 10% APY on the loan, and the same amount on Protocol B, offering 10% APY on cryptocurrency staking.
If she plans to use Protocol A and lend her funds over a period of 5 years, she will have 1,500 USDC at the end of the period. Regarding staking on Protocol B, her balance will be 1,610.51 USDC.
This increase is due to Alice’s compound interest over the years. The returns generated are directly reinvested, enabling significant growth in earnings over the long term.
The limits of APR and APY in DeFi
However, in the field of decentralized finance, a problem arises: interest rates on different financial investments vary over time.
This variation is due to the very nature of DeFi protocols, as rates fluctuate due to the permanent change in supply and demand, market conditions, but also user participation in these same protocols.
This means that APR and APY, initially displayed in decentralized protocols such as Aave or MakerDAO, can be modified upwards or downwards over time.
What are the advantages and disadvantages of using APR and APY in DeFi protocols?
Advantages of using APR:
- Simplicity: APR is a straightforward metric representing the annualized interest rate without accounting for compounding. It is easy to understand and calculate.
- Comparison: APR allows users to compare different lending or borrowing options based on the interest rates offered. It helps users evaluate the potential returns on their investments.
- Predictability: APR provides a predictable and stable interest rate over time. It does not fluctuate based on compounding intervals or reinvestment.
Disadvantages of using APR:
- Ignoring compounding: APR does not consider the effect of compounding, which can result in a difference between the stated interest rate and the actual returns earned.
- Misleading returns: In DeFi protocols, where compounding is frequent, APR might overstate the potential returns, leading to misleading expectations for users.
- Limited accuracy: APR may not accurately represent the true returns, especially in cases where compounding occurs regularly, or the interest is reinvested.
Advantages of using APY:
- Reflects compounding: APY considers the compounding effect, providing a more accurate representation of the actual returns on investment.
- Accurate comparison: APY allows more precise comparisons between investment options by considering compounding intervals and reinvestment strategies.
- Realistic returns: APY provides a better understanding of the actual returns that can be expected from an investment in DeFi protocols, considering compounding effects.
Disadvantages of using APY:
- Complexity: APY involves more complex calculations than APR, making it less intuitive for some users.
- Fluctuating rates: APY can vary over time due to changes in compounding intervals or reinvestment strategies, making it harder to predict future returns.
- Potential confusion: Using APY instead of APR might confuse users accustomed to the simplicity of APR calculations.
Conclusion on APR and APY
RPA and PYA are two measures for assessing financial costs and returns in different contexts.
The two measures differ in their uses and impacts. APR evaluates the cost of borrowing, while APY evaluates returns on savings and investment accounts.
What’s more, in DeFi, their initial rate may undergo changes over time, and the user needs to keep this in mind before using these protocols. It’s important to check rates on DeFi protocols often, because from one week to the next, it may be more profitable to change protocols in order to get better rates on another.