What Does APY Mean in Crypto? DeFi for Beginners

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What Does APY Mean in Crypto? DeFi for Beginners
What Does APY Mean in Crypto? DeFi for Beginners

One of the most appealing aspects of cryptocurrency investing is the opportunity to earn a high APY (Annual Percentage Yield). This is usually done through decentralised finance services (DeFi) or cryptocurrency exchanges.

Many DeFI and cryptocurrency platforms offer users much higher interest rates than they can obtain through traditional means such as high-interest savings accounts at banks. As a crypto investor, APY is a key metric to help you compare returns between platforms or assets.

In this article, we will be discussing what APY means, how it works in crypto and how it is calculated.

What is APY?

APY is the annualised rate of return on an investment that accounts for compound interest that accrues or grows with the balance. Compound interest includes interest earned on the initial deposit plus interest earned on that interest.

While APY is often associated with traditional savings plans, it is a key metric for crypto savings plans and works in a similar way. Crypto investors can earn APY by staking cryptocurrencies, depositing into savings accounts, or providing liquidity to liquidity pools through yield farming.

You can quickly start earning APY for your cryptocurrencies through cryptocurrency exchanges, wallets and DeFi protocols.

Typically, investors earn interest on the same cryptocurrency they deposit. However, in some cases, they can be paid in the same or different currencies.

How APY Works for Crypto

APY in cryptocurrencies works a little differently than traditional finance. The interest rate you get isn’t based on the dollar value of your holdings; it’s based on the number of assets on offer. For example, if you earn 5% APY and deposit 1 BTC, you will earn 0.05 BTC in interest after one year. The value of bitcoin does not affect the interest rate you get. This can make Crypto APY more attractive than traditional investment options. However, as mentioned, platforms will state an APY but may not actually be compounding for you.

There is something else to consider when looking at APY in cryptocurrencies, which is impermanent loss. The highest APY you can earn is always used for liquidity pools, where users deposit USD equivalents of both assets to earn transaction fee rewards. You may incur some impermanent losses using these liquidity pools, but as long as you earn more interest than you lose, it’s still a worthwhile investment.

How to Calculate APY

There is a formula for calculating APY. You must know the interest rate of the relevant account to use this formula.

Performing this calculation can help you estimate how much your money will grow over time. This is important if you have specific savings goals.

APY formula

Here’s what the APY formula looks like:

APY = (1 + r/n)n + 1

In this formula, r is the interest rate you earn on your deposit account, and n is the number of compounding periods.

There are several ways to calculate these numbers, including through a spreadsheet, but it’s usually easiest to use an APY calculator. Remember that you don’t usually need to calculate the APY since this is information your bank or credit union will usually provide.

The Difference Between Simple Interest Rates and Annual Percentage Yield

While APY refers to the projected annual rate of return on a deposit or equity after accounting for compounding, the simple rate only considers the interest earned on the original equity. Therefore, the main difference is that APY believes in compounding effects, where applicable.

Compound interest is a powerful investment tool because it allows you to earn additional income over time. Compound interest is calculated over a period of time, and the increased value is added to the balance. The total balance interest paid increases with each additional period.

The Difference Between APY and APR

Annual percentage yield (APY) and Annual percentage rate (APR) seem to be very similar since both are associated with interest. Some users even use the terms interchangeably. However, APY and APR are not the same.

As mentioned earlier, APY is the annual return on the capital invested or saved and the accumulated interest. In contrast, the APR is the annualised interest rate on a given debt.

When a user has a loan, their lender assigns them a specific APR. The APR can be fixed or variable depending on the loan type and user requirements. The APR is typically higher than a loan’s nominal rate because closing costs, insurance, and closing fees (processing fees for new loan applications) are considered. However, unlike APY, APR does not account for compound interest and is a simple interest rate.

For APY, a higher percentage is better since users earn more from their deposits and investments. However, the debt’s high APR means users have to pay more interest. The APR that a user must pay is usually tied to the user’s creditworthiness. If a user has good credit, they are entitled to a lower APR. If a user has bad credit, their APR will be high. On the other hand, APY has nothing to do with the user’s creditworthiness.

Since crypto lending does not involve credit scoring, the APR depends on market volatility. Like APY, the APR rises when demand is high and falls when the market is stable.

Conclusion

Annual percentage yield (APY) is the return on capital after accounting for principal and compound interest. A high APY means users earn more by depositing. Therefore, users looking to deposit cryptocurrencies should consider APY when comparing platforms. However, users should be aware that APY can fluctuate.

Most crypto savings options and liquidity pools offer over 1% APY. Some newer projects even offer more than 100% APY to deal with temporary losses and price swings. Therefore, users can take advantage of these pools to earn sizable profits. However, users should do their own research before depositing to prevent potential scams and rug pull.