Apr or Apy: How to Choose the Right Return Rate?

If you are investing in decentralized finance (DeFi) or traditional financial services, you have undoubtedly encountered two similar terms – APR and APY. Although these abbreviations sound alike, their differences are crucial for accurately calculating how much your investment will truly earn. Understanding these two metrics is critically important because misinterpreting them can lead to costly mistakes when choosing investment products.

What Does APR Mean – The Simple Annual Rate

APR (Annual Percentage Rate) is the best way to describe the simple annual interest rate. This term refers to the percentage you will earn from your investment over one year, without compounding interest. If this sounds confusing, here’s a practical example: suppose you deposit $10,000 into a bank account with a 20% APR. After one year, you would earn $2,000 in interest (10,000 × 20%), making your total $12,000.

If you kept your money in the bank, would it constantly earn interest on the interest? No. APR is a static, non-compounding measure. It only indicates the return on the initial investment, without any complicated calculations. After two years, you would have $14,000, and after three years, $16,000. The math is simple: just multiply the initial amount by the APR percentage and then by the number of years.

It’s important to understand that APR is often used in loans and credit products because it shows the true cost of borrowing over a year. However, in investment products, APR does not reflect your actual potential earnings because it does not account for compound interest.

APY and Compound Interest: Where More Profit Hides

Now we move to a more complex but much more profitable term – APY (Annual Percentage Yield). APY differs from APR in that it accounts for compound interest—that is, interest earned on previously earned interest. This effect can be incredibly powerful over the long term.

Let’s revisit our $10,000 example, but this time with a 20% APR and monthly compounding interest. Instead of $12,000, you would actually earn about $12,194. The same 20% APR, but $194 more in interest earned! The difference may seem small, but see what happens if compounding occurs daily—you would end up with approximately $12,213.

How much can compound interest increase your wealth over the long term? After three years at the same 20% APR, with daily compounding, you would have about $19,309. That’s $3,309 more than with simple APR! Now you see why APY is such an important metric—it shows your true return, considering the power of compound interest.

The frequency of compounding directly impacts your final earnings. Daily compounding always yields more than monthly or weekly compounding. That’s why, when converting APR to APY, you consider the compounding period. For example, 20% APR with monthly compounding corresponds to an APY of approximately 21.94%, while daily compounding at 20% APR results in about 22.13% APY.

Practical Comparison of APR and APY: When to Choose Which?

The most important step before investing in any product is to determine whether the figures are presented as APR or APY. Some products intentionally use APR because it appears lower and can mislead potential investors. Others use APY to show the actual return.

If you compare two DeFi products—one with 20% APR (monthly compounding) and another with 21% APY (daily compounding)—the first will actually give you less profit. Always convert both to the same format: either both to APR or both to APY. There are free online tools that can help you do this, considering the compounding period.

This tip is especially important when dealing with cryptocurrency products. Staking, delegation, and other DeFi yields often report returns in APY, but different products use different compounding periods. As a rule of thumb, before investing, do this simple check: if given APR, convert to APY; if given APY, find out the compounding period. A product with the same APR but daily compounding interest will yield more than one with monthly compounding interest.

Risks to Know: Crypto Assets vs Traditional Investments

While high APYs sound attractive, don’t forget the additional risk that comes with crypto investments. Unlike savings accounts, the value of cryptocurrencies is highly volatile. You might earn a great APY in crypto, but if the price drops, your investment’s USD or EUR value will be less than what you initially invested.

For example, if you invest $10,000 and earn 22% APY annually, your crypto holdings would be worth about $12,200. But if the crypto’s price drops by 30%, that $12,200 is only worth about $8,540 in fiat currency. This is damaging—you earned interest, but lost more due to price decline.

Therefore, when looking at any financial product claiming a high APY, it’s crucial to understand what you can do with that return. Is it in crypto? Is it in fiat currency? Is the platform trustworthy? These questions are even more important than the APY percentage itself.

Final Recommendations: Calculating APR for Real-World Products

APR and APY may seem confusing at first, but the main idea is simple: APR is a simple rate, while APY includes compound interest. APR never considers compounding, whereas APY always does—if you know the compounding period.

When should you use APR? When calculating loan costs or looking at bank products that do not pay compound interest. When should you use APY? When investing and wanting an accurate understanding of how much your money will earn.

In today’s financial landscape, where crypto products and DeFi platforms offer attractive APRs and APYs, always ensure you compare apples to apples. Convert APR to APY or vice versa. Find out the compounding period. And most importantly, remember that high returns usually come with higher risks. You are responsible for your investment decisions, so invest with knowledge and understanding of exactly what you are risking.

Information source: All information provided in this article is for educational purposes only. It is not financial advice and should not be treated as such. Before making any investment decisions, consult with your financial advisor.