What is APR / APY
APR represents the annual percentage Rate, while APY represents the annual percentage Yield. In crypto, APR is generally applied in lending/borrowing scenarios, which measures the amount of interest you’ll receive or be charged when you lend or borrow. On the other hand, APY is more used in the case of yield farming or providing liquidity, which measures the amount of interest you earn.
It's important to note that APR and APY are different measures, even though they both refer to interest rates. APR only takes into account the interest rate charged, while APY factors in the compounding of interest over the course of the year.
Let's use an example to make it clear. Suppose that you deposit $1 cryptocurrency with an APR of 5% and the interest is paid out at the end of the year. This means that at the end of the year, you will earn $0.05 cryptocurrency as interest, and your total balance will be $1 * (1+5%) = $1.05.
Now let's consider the same scenario, but with an APY of 5% instead. Let's first suppose that interest is compounded annually in this case. According to the formula of APY: Total Yield = (1 + (APY/n))^n (n - the number of times the interest is compounded per year), your total balance at the end of the year will be (1 + (5%/1))^1 = $1.05, which is the same as APR result.
However, if we assume that interest is compounded semi-annually, which means it would be compounded twice. Now, at the end of the first year, you will not only earn interest on your initial deposit but also on the interest earned in the first half of the year, which will continue to generate returns in the second half of the year. Your total balance will be (1 + (5%/2))^2 = $1.0506, which is slightly higher than what you would have earned with an APR of 5%.
What if we increase the compounding frequency? What would happen? Now let's assume daily compounding, which is 365 times a year. Your total balance will now be (1 + (5%/365))^365 = $1.0513, which is a higher return than before.
Therefore, the compounding effect of APY can result in a higher rate of return compared to APR, especially for long-term investments. The more frequently the interest compounds, the greater the difference between APR and APY.
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