Summary
APR - Annual Percentage Rate
APY - Annual Percentage Yield
Both are used to calculate interest for investment and credit products.
"APR measures the amount of interest you'll be charged when you borrow, APY measures the amount of interest you earn when you save." ~Capital One
When researching decentralized finance (DeFi) solutions, one has perhaps come across the phrases APY and APR, which have a similar sound.
Unlike APR, which stands for annual percentage rate, APY includes interest that is compounded quarterly, monthly, weekly, or daily. Calculations for returns over time may be significantly altered by this seemingly little distinction.
It is crucial to comprehend how these two measures are determined as well as what it means for the potential returns on your digital investments.
The Difference: APY vs APR
For the purposes of personal finance, APR and APY are both essential metrics. Start with the more straightforward method, the annual percentage rate (APR). It is the interest rate that a lender receives on their investment over the course of a year and that a borrower pays to use it.
For instance, if one deposits $10,000 into bank savings account with a 20% APR, after a year one will receive $2,000 in interest. By multiplying the principal ($10,000) by the APR (20%), the interest is determined. So, the investor will have a total of $2,000 after a year. The initial investment will grow to $14,000 after two years. The investor will have $16,000 in three years, and so on.
Understanding compound interest can help us better grasp annual percentage yield (APY. It refers to receiving interest on interest already received. If the financial institution pays interest to one’s account on a monthly basis, as in the previous example, the balance will change throughout the course of the year.
Consider depositing $10,000 in a bank account with a 20% APR and monthly compounding interest. You will receive $12,429 at the conclusion of a year, without delving into the intricate calculations.
The simple addition of compound interest results in an additional $429 in interest being generated. How much interest you would make if the APR was exactly 20% and interest was compounded daily? You would then receive $12,452.
Over time, compounding's power is more striking. With the same 20% APR product and everyday compounding, one can have $19,309 at the end of three years. In comparison to the identical 20% APR product without compounding, it is $3,309 more interest collected.
Investors may increase their income significantly by merely using compound interest. Also, take note of how the interest varies depending on the frequency of compounding. When compounding occurs more frequently, one earns. Individuals can earn more income from daily compounding than from monthly compounding.
How can one figure out how much one can make using compound interest on financial products? The annual percentage yield (APY) enters the picture here. Based on the frequency of compounding, an APR can be changed to an APY using a formula.
A 20% APR with monthly compounding results in an APY of 21.94%. It would equal 22.13% APY with daily compounding. These APY figures show the annualized interest returns one receives after taking compound interest into account.
Closing Thoughts
An easier and more constant metric is the annual percentage rate (APR), which is always expressed as a fixed annual rate. However, APY (annual percentage yield) includes compound interest or interest gained on interest.
Depending on the frequency of compounding, it alters. One method to recall the distinction is to keep in mind that "yield" has five letters one more than "rate" and that it also stands for the more intricate idea.
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