APR vs APY
- APR stands for annual percentage rate and does not include compound interest
- APY on the other hand, stands for annual percentage yield
- APY reflects interest paid on interest, which means action is needed to compound interest
- APY always show higher than APR
This article is going to shed some light on the differences between APR and APY. Although both terms look very similar and both of them have to do with interest rates, it is very important to know the difference between these two. Understanding the difference between these terms will help everyone make better decisions regarding money management.
In essence, APR stands for annual percentage rate and does not include compound interest. APY on the other hand, stands for annual percentage yield, and takes compound interest into account.
APR will tell you how much interest you will earn on your initial investment over a given period of time. To provide a more practical example: if your APR is 20% and you invest 100 USD for one year, at the end of this year your investment will be worth 120 USD.
APY will tell you how much interest you will earn on your initial investment and also the interest on your interest over a given period of time. To showcase this even better, if your investment bears a 20% APR and gets compounded on a daily basis (meaning that every day your interest also starts earning interest) your investment of 100 USD will yield 122.13 USD. This would signify an APY of 22.13%.
Looking at this example from an alternative perspective: If an investment opportunity offers you a 20% APR rate over one year you would end up with 120 USD on a 100 USD investment. If the same opportunity offers you 20% APY you would also end up with 120 USD but, your APR would have only been 18.24% (when applying daily compounding).
Why is the displayed APY always higher than APR for the same pool?
As mentioned, the difference between APR and APY is that one form of investment (APY) gets compounded every time period, whereas the other one shows you your potential gains without compounding effect (APR).
APY reflects interest paid on interest, which mean action is needed to compound interest. This action can be done either manually (i.e. users withdraw interest and stake it), or automatically, meaning the action will be implemented by the protocol. Due to this particular reason, APY is always higher than APR.
What is compound interest?
Compound interest is the interest rate one gets on their initial investment and also the interest that the earned interest earns. This means that the accumulated interest from previous time periods also earns interest.