Understanding APR vs APY: Making Better Financial Decisions
APR and APY are standards by which interest for borrowing and lending financial products. They are closely related and always mixed up because they determine how much you will pay or earn when applied.
Because one involves compound interest and the other doesn’t, understanding the difference between them, and how to calculate each will help you make good decisions when borrowing or lending assets.
The first step in understanding APR and APY metrics is understanding compound interest.
Compound Interest
“Compound interest is the eighth wonder of the world; he who understands it earns it; he who doesn’t, pays it”. — Albert Einstein.
In simple terms, compound interest involves earning interest on added interest. This means already earned interest is added periodically to the initial amount of a deposit or loan, and more interest is earned on that.
APR
If you lock up $100,000 in a bank’s savings account with a 20% APR, your interest at the end of the first year will be $20,000. After the first year, you will have $120,000, after the second year, you will have $140,000. This is calculated by multiplying the initial principal ($100,000) and the APR (20%).
The Annual Percentage Rate (APR) is used to calculate the interest you earn on your money/asset as a lender or the interest you pay on money/asset borrowed — over one year.
The effects of compound interest don’t affect the APR metric.
Financial Institutions mostly flaunt APRs for credit products — because it seems like borrowers have less interest to pay back.
APY
The Annual Percentage Yield (APY) works with the effects of compound interest.
APY compounds periodically — (Quarterly, Monthly, Weekly, or Daily), and the more frequently it compounds, the bigger the interest to be earned. For E.g., compounding daily earns more than compounding weekly.
In this case, if you deposit $100,000 in bank savings with a 20% APR and this compounds monthly, this means that after the first month, $1,666.67 will be added to the initial amount.
For the second month, the capital becomes $101,666.67 — you will earn an interest of $1694.44, which will also be added to the capital. This goes on and on each month.
By the 12th month (a year) your total balance will be $122,133 after earning an interest of $22,133 (a difference of $2,133 without compound interest).
This means that a financial product with a 20% APR compounding monthly is equal to a 21.94% APY. This will earn a 22.1% APY if compounded weekly, and a 22.13% APY if compounded daily.
Financial Institutions flaunt APYs to attract investors because it seems like there’s more interest to earn.
Comparing different interest rates using APR and APY
Because different financial products present their rates as either of these metrics, it is better to convert and use the same metric for comparison.
There are APY and APR calculators online to avoid mistakes.
The same goes for crypto. When comparing DeFi products with APY, make sure they have the same compounding periods. For clarity, two products with the same APY, but one compounds weekly and the other monthly — the one that compounds weekly may earn you more crypto interest.
APY may be offered in different contexts. This is why it is important to review terms and conditions and do your own research before engaging with a financial product.
Some crypto products that use APY refer to the rewards you will earn on that particular cryptocurrency, not fiat rewards. Crypto prices are always volatile — meaning that the fiat value of your investment may go up or down.
If the price goes down drastically, it means that the fiat value of your investment will be lower than what you initially invested, even though you have been earning interest.
In summary, APY and APR can be understood by understanding that one doesn’t compound, and one compounds more than once a year — earning more interest.
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