APR vs. APY for Crypto
What are these terms in essence, and how do they work to help you manage your crypto assets?
If you've tried your hand at investing in crypto interest accounts, you've probably seen the interest rate mentioned in terms of APR, APY, or both. Crypto platforms often use these terms interchangeably, even though they aren't. They can significantly affect how much is paid back for personal loans or the interest generated on a savings account. But when considering these platforms, what are these terms in essence, and how do they work to help you manage your crypto assets?
What are APR and APY?
Non-crypto investors are likely to see the terms APY and APR in different places. Annual percentage yield (APY) refers to the rate of return on investment when compounding is taken into account. On the other hand, the annual percentage rate (APR) is the return you get on investment without compounding, also known as the simple interest rate. These may seem like a straightforward comparison, but the terms can become confusing, especially when looking at their general use.
Financial institutions typically use APR to sell their credit-based products, such as personal loans, since it seems that the borrower is paying less in the long run. Investment companies usually use APY to sell their investment accounts since it looks to the client that their rate of return will be more after a year. Depending on the compounding frequency, this could indeed be true. Financial institutions calculate interest on a per-period rate, and this interest is compounded over a year.
Crypto savings accounts typically compound interest daily, weekly, or monthly, depending on the institution providing the account. Here's a list of platforms that pay compound interest.
The Differences Between These Interest Calculation Methods
It may not be immediately obvious how different these methods used to calculate interest are. However, the difference in final returns is significant and can change a person's outlook on a particular investment.
APR deals with simple interest. The calculation for simple interest means that the amount earned remains the same for any given year. The interest calculation doesn't consider any new profit added to the account. APY takes into account the additional interest earned and, as a result, gives better overall returns on investment. With each year, the amount of interest a person acquires will increase exponentially. Crypto savings usually rely on APY for their returns, even though some companies still offer simple interest for their accounts.
It's easier to demonstrate this difference with real numbers. Let's say investment companies offer a 1% APR on a deposit. We deposit 1,000 BTC into the account. After one year, our simple interest generated by the investment would be:
I = Deposit x Rate x Time I = 1000 x 0.01 x 1 I = 10 BTC
After a year, we'd get 10 BTC off of our 1,000 BTC investment. However, this rate remains constant. The following year, we'll only get 10 BTC as returns as well since the calculation doesn't involve the new interest added to the account. After a five-year investment, we'll have received 50 BTC as interest to the account.
Conversely, compound interest calculations in annual percentage yield are a bit more complicated. The calculation in this case involves:
Amount = P(1+rate/number of periods)^(number of periods x time)
So, taking our initial 1,000 BTC investment with a 1% rate compounded monthly, we'll get:
A = 1000(1+0.01/12)^(12x5) A = 1000(1.000833333)^60 A = 1051.25 BTC
The difference at this rate doesn't seem like such a huge difference. However, as the compounding interest rate increases, the returns on APR vs. APY are significant. APY is an exponential formula. It allows a person to build on what they've earned in the past. They can then use those earnings as a springboard to increase income. With interest compounded monthly, an investor could earn quite a bit from their money market account. With an annual percentage rate of return, an investor gets a straight amount from their deposit, regardless of how much that deposit has grown. The annual interest rate only looks at the principal balance, not the amount within the account when it calculates interest. The interest accrued from year to year is constant once the deposit remains constant.
Why Should I Pay Attention To APR and APY?
Personal finance enthusiasts would spend a long time explaining why these two terms are so important for proper money management. The simplest explanation is that annual percentage yield and annual percentage rate both play a massive part in how you earn interest on your deposit accounts. When you want to determine how much interest a particular account generates, the calculation is relatively simple when using these formulae. However, it's essential to figure out whether the financial institutions you're dealing with correctly use these terms.
Compound interest rates should be reflected as APY, while simple interest rates should be shown as APR. Each of these will determine how much interest a particular account will earn over a year. The monthly payments your crypto assets generate will increase over time if they're in a savings account. In a traditional bank account, it's less common to get compounded interest.
Is It Safer to Put Money In a Bank?
The truth is that bank accounts often don't offer clients compound interest on savings. Instead, the interest rate they quote solely deals with APR. Traditional institutions also provide much lower interest rates on deposits than cryptocurrency accounts. This approach is partly due to the consideration of inflation. Interest rates in these banks need to take inflation into account. To determine the actual interest rate that one earns on their account, one must look at the nominal interest rate. If the bank crashes, the deposited funds are covered under deposit insurance, ensuring that the holder will be reimbursed.
Putting money in a crypto savings account is a little riskier since many platforms aren’t covered by deposit insurance. However, the compound interest generated by these accounts can lead to significant gains on investment. Over time, as the interest compounds, the returns can quickly overshadow the safety that traditional banks can offer. Depositors can even borrow money from the institution they deposited their crypto assets into, increasing the potential for earning money from their holdings. One cannot earn significant gains without a certain level of risk. Crypto savings offer investors the best returns while still giving them peace of mind and security.