Understanding APR and APY: The Real Language of Interest

Source: CryptoNewsNet Original Title: Understanding APR and APY: The Real Language of Interest Original Link:

Introduction

Borrowing and lending has been parts of human financial environment since the dawn of civilization. Both parties desire to lay out the terms of return in a clear way. The lender want to get maximum interest, but the borrower want to pay as little as possible. Sometimes, institutions such as banks want to lend money only to get back more than they lend. In the world of digital currencies, exchanges and developers want investors to buy and hold their tokens. For this purpose, they offer competitive APYs or APRs. This article sheds useful light on the difference between these two often-quoted terms in the finance literature.

What is APR?

The simpler of the two terms, APR stands for annual percentage rate. APR refers to the interest rate that a lender earns, and the borrower pays over the period of one year. It is simpler because it does not involve compounding effects of the interest.

Let’s take an example to understand the point. If you place $8,000 in a savings account that offers a 15 percent APR, you will earn $1,200 in interest at the end of the first year. The return is calculated by multiplying the original deposit of $8,000 by the stated annual rate of 15 percent. This gives you a total balance of $9,200 after one year. Using the same method of calculation, your balance will rise to $10,400 after two years. By the end of the third year, your savings will reach $11,600, and the pattern continues in the same way.

What is APY?

Annual percentage yield (APY) takes into account the compounding effects of interests on interest you have already earned. However, it does not mean that a banking product or a crypto token which has published only APR does not compound the interest rate. So, APY is the actual annual return on an investment once compounding is included. We can say that APY shows the full picture of the lenders’ gains by considering the growth of the loan. Also, most crypto assets show APYs instead of APRs. It can help investors compare the assets fairly.

If we take the previous case with $8000 investment to understand APY this time, the compounding rate must be determined beforehand. If you put this amount in a crypto coin offering a 15% APR with interest compounding every week, the growth of your savings changes considerably. In this case, the weekly rate is the annual rate divided by 52, and each week your balance increases slightly before the next calculation is made. By the end of the year, the formula gives you an effective annual yield of a little more than 16%. As a result, your $8000 grow to roughly $9290 after one year.

This example shows how APY captures the real impact of frequent compounding and explains why it always reflects a higher and more accurate return than the nominal APR. The compounding effect become more prominent if we extend the gains to a longer duration. The following table visualizes the compounding effect of APYs put against nominal APRs with an initial investment of $8000.