When exploring DeFi protocols to generate passive income by staking, yield farming, providing liquidity, and lending your digital assets through smart contract-powered decentralized applications (dApps), it is critical to track the performance of your investments and how the percentage increases to determine how much you earn on each DeFi protocol asset.
However, to keep track of your investments, their ROI is a critical factor to consider. As a result, the terms APR and APY are used to calculate the percentage increase in your investment's interest rate. Although the two terms appear to be the same, they are calculated differently. Let us discover the distinction!
What is APR?
APR stands for Annual Percentage Rate, which describes how much interest you will accrue over a year. The APR is the financial value or reward investors may receive by making their cryptocurrency tokens available for loans and any other DeFi investments, considering the interest rates. Since APR is essentially a simple interest rate, your profit will depend solely on your initial investment and will not account for interest that accrues on interest from earlier investments.
For instance, if you invest $10,000 at a 15% APR into a DeFi protocol, you will receive $1,500 in interest after a year. The initial deposit, the principal amount ($10,000), and the APR are multiplied to determine your interest rate (15%). So, at the end of the year, you will have $11,500 in total. If you continue with the protocol for another year, with $11,500 as your principal amount, at the end of the year, the interest is multiplied to get the total. Hence, here is a manual APR calculation formula as a result.
APR = Annual Percentage Rate x Number of Periods in a Year
What is APY?
The APY is the annual rate of return on an investment, which includes compound interest that accumulates or grows over a year. The interest earned on the original deposit is compounded with interest earned on the interest.
Similarly, the annual percentage yield (APY) in DeFi calculates the amount earned over a year on an asset investment in a money market account. APY is the annual compounded return on your asset investment, expressed in percentages. It is calculated by multiplying the initial investment by the interest earned on that investment.
In other words, APY considers compounding effects. The interest you earn on your asset is referred to as compounding interest. It refers to the return on your initial investment (the money you put into the protocol) and the accumulated interest. Compounding is a method of making money over time.
APYs are constantly changing in the crypto world. As a result, the APY displayed on exchanges, liquidity, and staking pools is frequently a guess. The APY of a market asset rises as the volatility of its supply and demand rises. Here is the formula for APY.
APY = (1 + r/n)^n-1
Where r = interest rate, n = number of compounding days.
However, since APY pays interest on both your initial investment and the interest earned, it is best to convert the APY to daily interest so you can see how much money you make daily.
Daily yield = total number of staked tokens × (APY for the staked token ÷ 365)
For example, what is your daily yield if you invest $10,000 in a DeFi scheme with a 15% APY? Let us all find out together.
Total number of staked tokens = $10,000. APY for the staked token = 15%
Daily yield = $10,000 × (15% ÷ 365)
Daily yield = $4.11
Since the DeFi scheme investment promises 15% APY, your $10,000 investment will earn $4.11 daily.
APY calculates interest on interest and compounds to increase the initial capital deposited in the protocol, which accounts for all the principal's interest accrued over time. As a result, depending on the protocol's predetermined duration, APY interest may compound continuously, daily, monthly, or yearly. The frequency determines the amount of interest applied to the initial principal.
APR vs. APY: The Difference
APR and APY both serve the same purpose in a protocol but produce different results. The significant difference between the two is the compounding effect that APY considers. In the long run, compounding development can significantly impact investment. As a result, APYs are frequently higher than APRs.
APR uses simple interest and does not put compounding into account.
The critical element of the APY is the compounding effect.
APR is recommended and applicable to borrowers.
APY is mostly applicable to lenders/investors.
APR gives an estimate of potential earnings.
APY is the most accurate predictor of an account's earning potential.
When investing in DeFi protocols, it is critical to understand both APR and APY. The more significant the gap between APR and APY, the more frequently interest compounds. However, investments with an APR or an APY provide investors with substantial long-term returns.
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