APR vs. APY
Definition
APR (annualized percent rate) is the interest made after one year of an investment without compounding the interest or gains. If you include compounded interest, you now have APY. APY (annualized percent yield) is the interest made after one year of an investment with auto or manual compounding included.
All you need to know
APR and APY both reflect the interest made from an investment over one year. The difference is that APY includes compounding your interest, while APR does not. APY in DeFi is an estimate based on historical averages and does not guarantee future returns.
There are a variety of opportunities in DeFi to collect yield on your investments. When you visit different projects in search of yield, you might see APR or APY and wonder why one term is displayed and not the other. When a project does not offer auto-compounding, they will report your annual interest as APR. When a project does offer auto-compounding, they mathematically derive the APY using the equation:
In this equation, n reflects the rate of compounding interest in a year. If you auto-compound daily, n = 365. If you auto-compound weekly, n = 52. If you compound monthly, n = 12.
Example: A staking pool has a 24% APR. They have an auto-compounding feature that will automatically reinvest your tokens every day. When you turn on auto-compounding, your APY is 27.11%. As you can see, your total returns are higher when you compound your interest.
On a side note, you might be familiar with APR from credit cards. In this case, they are charging you so they want to show you the smaller number. However, that APR does auto-compound if you miss payments and the APY ends up being much higher. Always read the fine print, friends.
Unlike fixed yield products (think things like bonds and CDs), APRs for DeFi investments (like staking and liquidity providing) are likely to change over time. This is because your returns on DeFi investments are dynamically calculated to ensure fair distribution to all participants. For example, in the DeFi Land staking pool, your share of the fixed emissions is proportional to your weight in the staking pool divided by the Total Value Locked in the staking pool. If a large investor removes their position from the staking pool, your percent share of the staking pool will increase and your APR will increase.
Be smart when chasing APY in DeFi. Protocols will lure users in with high APY, but it is important to remember to only put your hard-earned tokens into projects you understand. You’ll notice that higher APY generally correlates with higher risk and volatility. The APY for stablecoins and bluechips is typically low, while the APY for risky lending platforms is high. Here are some questions you should ask and red flags you should consider:
Do I understand the project? If you don’t understand what you are investing in, don’t even touch it. Instead, continue your learning journey!
Does a 1000% APY mean my investment is going to be worth 10x after a year? No. Protocols usually take a 7-day or 24-hour average to estimate APY. The APY could dramatically change very quickly. Additionally, if you are seeing an extremely high APY, you are likely looking at an investment that involves significant risk. The advertised APY does not account for price changes in the underlying investment or rewards.
What is the currency for the rewards? A protocol might offer high APY but the payout is in a random token that is printed to generate the rewards. These are often called “reward tokens” and have no enduring value.
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