One of the most attractive aspects of cryptocurrency investing is the possibility of obtaining high APY (Annual Percentage Yield). Decentralized funding services (DeFi) or cryptocurrency exchanges are often used for this purpose.
The interest rates that many of these DeFI and cryptocurrency platforms provide to users are much higher than what they could get through traditional avenues, such as a high-interest bank savings account. However, you’ve likely seen APY and APR mentioned in different services. So what is the difference? What is APY and how does it work in cryptocurrency? Are the returns really as high as claimed?
What is APY?
Annual Percentage Yield, or APY, – is the realized rate of return on investment. It takes into account the effect of compound interest.
Compound interest is automatically added to the principal balance periodically, which increases the total amount of interest accrued. Over time, this results in higher yields than APR as the total amount invested increases.
What is the difference between APY and APR?
Annual interest rate, or APR, – is the rate obtained for the entire period without compound interest.
APR uses simple interest, meaning that earnings are not automatically added to the principal amount owed. The only real difference between the two types of interest rates is the difference between compound and simple interest.
Why do some platforms use APR and some use APY?
Banks, financial institutions and cryptocurrency platforms use APR and APY interchangeably to make an attractive borrowing rate or lending rate.
Loan services usually exaggerate the APR because it does not take into account compound interest, which gives the impression of a lower fee. Many borrowers will be scared off if they find out how high the interest can be if they do not repay the principal by the due date.
Loan servicers tend to emphasize APY for the opposite reason: it makes the interest rate the lender will receive for lending the asset look much more attractive. This helps to attract many investors, as the figure turns out to be higher than the APR. However, many cryptocurrency lending services tell you the APY but don’t do the interest compounding themselves. This means that if you don’t manually compound interest, you’ll only get an APR and no benefit of compounding interest. DeFi services and cryptocurrency exchanges often have options for automatic compounding and simple interest accrual.
How APY for cryptocurrencies works
APY in cryptocurrencies works a little differently than in traditional finance. Instead of receiving an interest rate based on the dollar value of your assets, you receive an interest rate based on the amount of assets you’ve contributed. For example, if you were earning 5% APY and deposited 1 bitcoin, you would receive 0.05 BTC in interest after one year. The value of bitcoin does not affect the amount of interest you receive. This can make cryptocurrency APYs much more attractive than traditional investment options. However, as mentioned earlier, platforms indicate the APY, but it may not actually accrue.
There is another thing to consider when looking at APYs in cryptocurrencies, and that is volatile losses. The highest APYs you can get in cryptocurrencies are always related to liquidity pools, where users deposit two assets in equivalent dollar amounts to be rewarded with transaction fees. When using such liquidity pools, you are likely to experience intermittent losses, but as long as the interest rate you receive outweighs these losses, it is still a profitable investment.
What to expect from cryptocurrency returns
As discussed in the previous section, the returns of cryptocurrencies depend on the volume of the asset delivered. This can lead to extremely high returns if the asset grows in value in conjunction with earning compound interest.
The main thing to note is that for many DeFi services, the rate decreases over time as more users add their assets to the pool. Many of these services also have higher payouts in the beginning to attract interest and then lower them to realistic numbers. When liquidity pools first launch, they always have very high APYs because there are very few assets coming in. Depending on how quickly users add liquidity, the APY can drop exponentially in minutes.
With centralized services like Crypto Earn, interest rates can also decrease over time, but they are not as easy to change without warning because they have to follow certain rules. This means that the interest rate can drop from 5% to 3%, but this will be done as a change at the end of the term, not on the fly as with DeFi.
In general, the typical return on crypto assets on the exchange is 2-15%, with more for stable coins and less for popular assets such as Bitcoin and Ethereum.
For DeFI services such as liquidity pools, the rates can be much higher, but as discussed above, they can fall quite quickly. However, for a short period of time, benefits such as 1000% APY can be taken advantage of, after which they will drop back to normal levels as users add liquidity. For more stable DeFI services such as vaults, interest rates are about the same as on the exchange, but may be lower if there is a lot of supply and little demand for the borrowed asset.
In general, expect returns to be higher than traditional savings accounts or bonds, but don’t expect ridiculously high interest rates to stick around for too long if they are available.
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