When it comes to managing your finances, it’s essential to understand common financial terms that can seem confusing. Two acronyms are frequently put forward: “APR” and “APY”. Although they may seem similar at first glance, they actually represent different concepts. These concepts are all the more important to know before using decentralized finance (DeFi) protocols. Focus on the differences between the APR and the APY.
What is APR?
The Annual Percentage Rate (APR) or Total Annual Effective Rate (APR) in French, is A rate that represents the total cost of a loan or credit to the borrower.
It includes not only simple interests, annual yieldthat is to say the percentage of gain or loss made on an initial investment, but also fees and charges associated with the transactionsuch as transaction fees for example.
In the context of DeFi, the APR measures potential performance that the user can earn by lending or borrowing their cryptocurrencies in protocols.
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What is APY?
The Annual Percentage Yield (APY) or Annual Rate of Return (TRA), expresses the annual return on an investment. It allows investors to get a clear idea of how their money has grown over a period of one year.
The Annual Percentage Yield takes into account compound interestwhich are accumulated over time, and which we will explain in more detail later in this article.
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What are the differences between APR and APY?
APR and APY are therefore two metrics used to assess financial costs and returns. However, there are notable differences.
APR is used for loans and creditswhich makes it possible to reflect the overall cost of the loan, while APY is used on savings and investment accountsbecause it leads to a higher overall yield.
Additionally, unlike the APR which only takes into account the base rate and associated fees, the APY takes into account interest rates, but also the effects of compound interest and its reinvestment over time, thus allowing a greater yield to be obtained.
Let’s take the example of Alice holding 1000 USDC on protocol A offering 10% APR on lending and the same amount on protocol B offering 10% APY on cryptocurrency staking.
If it plans to use Protocol A and lend its funds over a period of 5 years, she will hold 1,500 USDC at the end of the period. In the case of staking on protocol B, his balance will be 1,610.51 USDC.
This increase is due to the compound interest that Alice has been able to accumulate over the years. The returns generated are directly reinvested, allowing for significant earnings growth over the long term.
Simulation of the evolution of Alice’s portfolio depending on the selected protocol
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The Limits of APR and APY in DeFi
However, in the field of decentralized finance, a problem appears: interest rates on different financial investments vary over time.
This variation is due to the very nature of DeFi protocols, because rates fluctuate due to the permanent change of supply and demand, market conditions, but also user participation in these same protocols.
It means that the APR and the APY, initially displayed in decentralized protocols such as Aave or MakerDAO, can be modified upwards and downwards over time.
Conclusion on APR and APY
APR and APY are therefore two metrics for assessing financial costs and returns in different contexts.
These two measures are different due to their uses and impacts. The APR evaluates the cost of borrowing, while the APY evaluates the returns on savings and investment accounts.
Additionally, in DeFi, their initial rate may undergo changes over time and the user should keep this in mind before using these protocols. It is important to check the rates on DeFi protocols often, because from one week to the next, it may be more profitable to change protocols in order to have more advantageous rates on another protocol.
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This article was written by Maksym Andrushkiv from the KryptoSphère student association
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