APR vs APY: What’s The Difference & Why It Matters
APR vs APY: What's The Difference & Why It Matters | Credit: Shutterstock
Key Takeaways
- APR and APY communicate a better picture on the total borrowing costs and potential investment returns in an effort to help users make informed financial decisions.
- APR illustrates the borrowing costs when taking out a loan, combining the loan interest rate and fees.
- APY measures the compound interest-driven returns attainable on an investment or savings.
- In decentralized finance, crypto lending, staking, and trading involve APR and APY concepts.
What Is APR & APY?
APR and APY are used as financial tools to communicate the cost of borrowing or potential returns on savings and investments. Understanding their difference matters because it helps individuals make informed decisions about loans, savings, and investments.
Annual Percentage Rate (APR), Explained
APR is a metric associated with borrowing money, in the form of loans or credit cards. It aggregates the interest rate and any other associated fees, offering borrowers a picture of the total cost of their loan over a year. Lenders are mandated to disclose APR figures by law. Consumers are then better positioned to make effective comparisons between various borrowing options.
Annual Percentage Yield (APY), Explained
APY falls into savings and investments. It accounts for the effects of compound interest, reflecting the total interest earned over a year. APY calculations might not incorporate bonuses. Financial institutions are required to disclose APY figures, so that savers can select accounts that offer the highest potential returns.
APR & APY In Crypto
In the context of cryptocurrencies, APR and APY are frequently employed in decentralized financial applications such as yield farming, liquidity provision, lending, and borrowing platforms. For instance, you may lend your cryptocurrency assets to other users on a platform that facilitates cryptocurrency lending and receive interest; this interest might be shown as an APR or APY.
Suppose you put $1,000 into a platform for lending cryptocurrencies with a 10% APR. You would earn $100 in interest over the course of a year. However, you can more accurately predict the potential increase in your investment over time with APY. As a result of taking the compounding effect into account, it is typically higher than APR. Using the same example as earlier, if you had a 10% APY, compounding would cause your actual returns to be a little bit greater than $100.
How Are APR & APY Calculated?
APR Calculation
APR calculation factors in costs associated with borrowing, such as interest, fees, and other charges. It provides a picture of the annual cost of borrowing. Its formula is made up of variables including:
- Fees: factor encompasses the total charges attributed to the loan, while
- Interest: represents the cumulative amount paid in addition to the principal.
- Principal: refers to the initial loan amount
- n: signifies the number of days making up the loan term.
APR = ((Interest + Fees / Principal) / n)) x 365 x 100
APR Calculation Example:
Let’s break down the APR calculation with a simple example:
Suppose Bob wishes to purchase Bitcoin and is considering a loan of $1,000 with an interest rate of 5% and a $50 processing fee to invest in the cryptocurrency. If the loan term is 30 days the APR would be calculated as follows:
Hence the variables would look as follows:
- Principal (P) = $1,000
- Interest (I) = Principal (P) × Interest Rate = $1,000 × 0.05 = $50
- Fees (F) = $50
- n (loan term) = 30 days
Plug these values into the APR formula:
APR = ((Interest + Fees) / Principal) / n) × 365 × 100
APR = (($50 + $50) / $1,000) / 30) × 365 × 100
APR ≈ 39.59%
In this example, the APR for the loan would be approximately 39.59%. This means that the annualized cost of borrowing this loan, including both the interest and the processing fee, is around 39.59% of the loan amount.
APY Calculation
APY calculation accounts for compound interest, which tells the story on the overall yield of savings or investments. The factors listed below collectively determine the APY, providing a more accurate representation of the investment’s growth potential. Its formula is made up of variables including:
- Nominal interest rate (r): Is the initial percentage used to calculate interest on a loan.
- Frequency of compounding (n): Determines how often interest is added to the principal.
APY = (1 + r/n )n – 1
APY Calculation Example:
Suppose Anne has invested in Bitcoin and is forecasting that the investment will have a nominal interest rate of 6%, compounding quarterly. If Anne wants to calculate her APY to understand the overall growth potential of investment over a year she must do the following:
Plug in the information into the variables:
- Nominal interest rate (r) = 0.06 (6% expressed as a decimal)
- Frequency of compounding (n) = 4 (quarterly compounding)
Plug these values into the APY formula:
APY = (1 + r/n)^n – 1
APY = (1 + 0.06/4)^4 – 1
APY ≈ 0.061678
APY ≈ 0.061678 * 100 ≈ 6.17%
In this example, the APY for the investment would be approximately 6.17%. This means that over the course of a year, with quarterly compounding, Anne’s investment is projected to grow by around 6.17%.
Borrower vs. Saver Perspective
Borrower’s Consideration
For borrowers, understanding APR is vital when considering entering into loans. A lower APR translates to reduced borrowing costs. However, borrowers should be cautious as APR might not reflect the effects of intra-year compounding, potentially leading to higher effective interest rates than initially perceived.
Saver’s Consideration
Savers seeking high-yield savings accounts benefit from learning APY. The frequency of compounding greatly impacts savings growth, the more frequent compounding happens surrounding investing, the more this yields higher returns. Comparing APY figures allows savers to optimize their earnings potential.
How APR & APY Are Used In The Crypto Industry
In the world of decentralized finance (DeFi), platforms offer lending and borrowing services where users can earn interest on their crypto holdings or borrow crypto assets. The concepts of APR and APY are applicable in this context.
Crypto Lending And Borrowing
In crypto, borrowers can collateralize their crypto assets and borrow other cryptocurrencies or stablecoins. The interest rates offered on these platforms are often expressed as APR.
APY In Crypto Staking
In proof-of-stake (PoS) cryptocurrencies, holders can “stake” their tokens to help secure the network and, in return, earn staking rewards. These rewards are similar to interest and can be thought of as APY. The more frequently rewards are distributed and compounded, the higher the APY.
Trading And APR/APY
While not a direct correlation, traders in the crypto market might encounter concepts similar to APR/APY in the form of funding rates on derivative exchanges. These rates reflect the cost of holding a position in a perpetual futures contract and are typically expressed as an APR.
How Does Understanding APR & APY Help Make Informed Financial Choices?
In the crypto landscape, being well-informed empowers individuals to make sound decisions without being blindsided by financial products offered. Both APR and APY play distinct roles in different financial scenarios, guiding borrowers and savers in their choices.
While a low APR might seem attractive for borrowers, it doesn’t factor in compound interest, potentially lacking essential information for informed financial choices. In contrast, APY considers compound interest and provides insight into its impact on your funds.
Comprehending the distinction between these two terms is pivotal for enhancing financial management and well-being. Remember that APR typically relates to loans, while APY is more relevant to savings and investments.
When evaluating loans, APR helps borrowers grasp the actual cost, while APY assists savers in selecting accounts that maximize returns. Recognizing the differences between the two terms aids in making prudent financial decisions aligned with borrower and savers’ individual goals.
Conclusion
The difference between APR and APY is pretty fundamental to financial understanding for those that are entering into loans or trusting third parties with their capital. Both are tools for assessing costs and returns, enabling individuals to navigate the intricate world of finance with clarity and confidence.
FAQs:
What is the difference between APR and APY?
APR represents the total cost of borrowing, encompassing interest and fees. APY, on the other hand, gauges total interest earned from savings or investments, accounting for compound interest effects.
How is APR calculated?
APR calculation considers interest, fees, and charges, providing the annual borrowing cost. The formula includes fees, interest, principal, and the number of days in the loan term.
How is APY calculated?
APY calculation incorporates compound interest effects. The formula involves the nominal interest rate, frequency of compounding, and the number of compounding periods in a year.
How are APR and APY relevant in crypto lending and staking?
In crypto lending, APR represents interest rates for borrowing or earning on crypto holdings. APY is akin to interest earned through staking, with higher frequency of compounding leading to higher APY.
