Do you really distinguish between APY and APR? The hidden traps of DeFi finance.

Question

Many people are confused when they encounter DeFi products, seeing the two indicators APY and APR. They sound almost the same, but in reality, they are very different. Misunderstanding these two concepts could result in earning several hundred more or potentially losing over a thousand on the same principal after a year.

Annual Interest Rate APR: The Easiest Way to Understand Returns

Let's start with the basics. APR is the annual interest rate, and the calculation is straightforward: principal × interest rate = annual return.

For example: If you invest $10,000 with an annual interest rate of 20% (APR), you can earn $2,000 in interest after one year, bringing your account balance to $12,000. In the second year, you continue to calculate 20% on the principal of $10,000, earning another $2,000, for a total of $14,000. This is what is called “simple interest” - earning interest only on the original principal and never on the interest itself.

The advantage of APR is that it is easy to understand, while the disadvantage is that it is “too honest”.

The Magic of Compound Interest: Interest Earns Interest

The attractiveness of DeFi products largely comes from compound interest. What is compound interest? Simply put, it means that your interest also starts to earn interest.

It's still the example of $10,000 with a 20% APR, if the platform settles interest once a month:

Month 1: Earn about $167 (10,000×20%÷12)
Month 2: The base amount has increased to $10,167, continuing to earn about $169.
Month 3: The base has increased again, continuing to earn about 171 dollars.
…and so on

Over the course of a whole year, you didn't earn $2,000, but rather $2,429—compound interest helped you earn an extra $429.

The higher the compounding frequency, the more powerful the effect. If settled daily under the same conditions, you could earn $2,452 in a year. It seems like just an extra $23, but this is only the first year.

If you extend the time to three years, with a daily compounded 20% APR, your account balance after three years will be $19,309. In contrast, if calculated with simple interest (which is the APR), you would only earn $6,000 over three years, resulting in an account balance of $16,000. The same amount of money, due to the existence of compound interest, can earn an additional $3,309 in three years. This is the power of compound interest.

APY Debut: Converting Compound Interest to Annualized Yield

Compound interest is so powerful, but the question arises - how do I know how much I can actually earn? This requires using APY (Annual Percentage Yield) for a standardized measurement.

APY is the “annual percentage yield” that converts the effects of compound interest for easy comparison. Calculated using the formula:

20% APR compounded monthly = 21.94% APY
20% APR compounded daily = 22.13% APY

This means that choosing a product with daily compound interest can yield an actual annual interest rate that is more than 2 percentage points higher than the simple interest situation.

How to Choose DeFi Products

The current problem has become more complex: different platforms use different standards. Some display APR, while others display APY. Although some all display APY, the compounding frequency is different.

General Principle: Always unify to the same metric for comparison.

For example, Product A is labeled at 15% APY (daily compounding), while Product B is labeled at 16% APR. You can't simply say “B is higher” because it's not comparable. You need to first convert B's APR to APY, which may result in only 17.2% APY, so that a real comparison can be made.

Another easy pitfall is that some cryptocurrency products use “APY” to represent the amount of cryptocurrency you can earn, rather than its fiat value. For example, a staking product promises a 50% APY, which sounds explosive, but if that cryptocurrency depreciates by 70% during the same period, the fiat value of your investment is actually a loss. In this case, even if you do earn the APY yield in cryptocurrency, your principal has already shrunk in fiat terms.

Practical Comparison

Looking at two DeFi products at the same time:

Product A: 12% APR, monthly compounding
Product B: 11.8% APY, daily compounding

At first glance, A seems higher. But using the same standard, A's 12% APR compounded monthly is approximately 12.68% APY, which is actually lower than B's 11.8% APY. Moreover, B's daily compounding will continue to accumulate, leading to better long-term returns.

Remember to keep in mind

APR is a static interest rate, while APY is a dynamic yield. APR does not take compounding into account, whereas APY fully encompasses compounding. As long as the compounding frequency is more than once a year, APY will inevitably be higher than APR.

When choosing DeFi products, it is essential to:

Confirm whether the product label is APR or APY
If it is APY, understand the compounding frequency (daily compounding > monthly compounding > yearly compounding)
Convert all products to the same standard before comparing.
If it involves cryptocurrency assets, be wary of the risks brought by price volatility.
Carefully read the product terms, the actual meaning of APY may vary in different scenarios.

Understanding the difference between APY and APR is essential to accurately calculate the returns on DeFi investments. Don't let the power of compound interest slip away from your fingertips by neglecting this detail.

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