Decentralized Finance (DeFi) and its attractive interest rates have turned crypto lending mainstream. Nowadays you can make money off existing crypto assets simply by depositing them on a lending protocol. And have no doubt, the interest rates on lending protocols are much higher than what any bank currently offers.
But one thing that many beginners don’t understand is how these protocols calculate interest. Moreover, they encounter two terms which many financially-illiterate crypto investors hear for the first time: APY and APR.
In this article, you will find out the difference between APY and APR, as well as see how the two compare against each other. I will also provide you with a quick overview of how crypto lending works and the mechanics behind it.
What Is Crypto Lending & Staking?
You’ll encounter interest rates in two crypto areas: lending and staking. I have decided to explain how both staking and lending work since APR and APY are highly prevalent in the two.
Crypto Staking (PoS)
Blockchain networks that utilize the Proof of Stake (PoS) consensus mechanism rely on staking to secure their networks. Staking assets means depositing the network’s main token to a validator. The validator, who acts as a good actor, locks these assets away while confirming transactions on the blockchain.
The purpose of staking is to prevent 51% attacks. A 51% attack happens when a bad actor controls more than 51% of a network’s assets. He can then control the network by issuing and voting on governance proposals or negating other users’ powers. Staking steps in by ensuring that a majority of the assets are owned by good actors.
Validators and end-users earn passive income for securing the network. They gain tokens while keeping their original assets for as long as they stake. For example, investors who stake Ethereum earn 4-5% in annual interest (denominated in ETH).
Crypto Lending (DeFi)
In DeFi, investors can stake assets and provide them as collateral to various protocols. Protocols will take and manage the assets based on the design of their investment strategy. The user earns interest in return.
For example, lending protocol AAVE allows investors to borrow and lend cryptocurrencies. Lenders provide collateral to AAVE, which the protocol uses to supply borrowers with assets. Borrowers have to return the assets (along with additional interest) by a certain date. The lender earns the interest provided by the borrower.
If the borrower fails to return the lended assets, AAVE will liquidate his position and return the assets back to the lender. If returned, the loan is completed as planned.
Yield farming protocols are another place where investors can stake. These protocols manage assets and carry out investing strategies by interacting with liquidity pools. Investors can accrue interest by staking assets on profitable protocols. Yield farming offers higher interest rates because the strategy carries a much higher risk, but also higher rewards.
APY vs. APR: What Is the difference?
Whether you interact with Ethereum 2.0, AAVE, or Yearn Finance, you’ll still encounter the same two terms: APR and APY rates.
APR stands for annual percentage rate. It represents the interest rate you earn annually while lending assets to a borrower. If you lend $1,000 and the lending protocol guarantees a fixed 10% APR, you will earn $100 by the year’s end. This means you’ll have $1,100 in total (while disregarding any volatility on your crypto assets).
APY stands for annual percentage yield. Compared to APR, APY also applies a special magic trick called compounding. Compounding is what happens when you apply interest on top of new interest payouts. What does this mean exactly? Let me show you with an example.
Let’s say you want to lend $10,000 in USDT on AAVE for a full year with monthly interest payouts. You can expect the following returns at an APY rate of 1.38%:
1st month: $10,138
2nd month: $10,279
3rd month: $10,422
4rd month: $10,567
5th month: $10,713
6th month: $10,862
7th month: $11,013
8th month: $11,166
9th month: $11,321
10th month: $11,478
11th month: $11,638
12th month: $11,799
What happened here is that the protocol applied the 1.38% APY rate after every monthly payout. Instead of earning interest in one swoop on your original deposit, you have earned interest every single month – resulting in more funds.
Alternatively, think of it like this. Let’s say you have $10,000. Would you rather open a long ten times and profit 10% every trade or take a single 100% trade? The latter means earning $10,000 (for a total of $20,000) while the former means earning $25,937 – that’s 29.6% more profits!
The power of compounding gives you a competitive edge in life. It allows you to increase your rewards in return for patience. Always compare APY and APR rates when interacting with a lending protocol. Doing so will help you reap better rewards.
To conclude, APR is a simple and fixed yield that you earn on an annual basis that you can easily calculate. APY is an interest rate that is compounded on a daily, weekly, monthly, or quarterly basis. The higher the interest payout frequency, the higher your final rewards will be.
Interest rates can be either flexible or fixed. Fixed rates remain the same throughout the entire lending period. Flexible rates change in tune with market volatility. There are also variable rates, which change based on the ratio between lenders and borrowers on any given asset.
If you’re not sure which one to pick, I suggest sticking with fixed rates. The market is quite volatile and can move your interest up and down quite frequently. Unless you’re absolutely certain that a bull market is ahead, you’re better off with the lower yet stable interest offered by fixed lending.
Each asset has its own interest rates. They also have differing fixed and flexible rates. DeFi protocols can also offer you to choose between locked and unlocked lending or staking.
Locked staking means that you have to lock your assets during the staking period. This period can last from a few weeks to several months. Staking with higher lock-up periods grants better rewards. However, the problem is that you can’t unlock and sell your assets in the event of bearish market conditions.
Unlocked staking allows you to lock and unlock your assets whenever you want. You can take your rewards, as well as original assets. However, a protocol might not give you the interest for a period if you withdrew before the periodical payout. For example, if you have a weekly payout and you staked on Thursday, you need to unstake on Thursday in order to receive your interest.
Investors generate interest when staking or providing collateral to lending protocols. The interest generated can be represented by two figures: APY and APR.
APR represents a stable and fixed interest rate that is applied on top of your deposit. On the other hand, APY is a compounded version of APR in which interest is applied on top of each periodical interest payout. The compound effect has a positive influence on your generated profits because it increases them.
I recommend you to calculate and compare APR and APY rates in order to get the best deal possible. However, I also want you to keep in mind that fixed/flexible and locked/unlocked lending represent important metrics as well. Research everything before lending or staking for the best results.
If you want to learn more about lending and staking, I recommend you reading the following articles:
Marko is a crypto enthusiast who has been involved in the blockchain industry since 2018. When not charting, tweeting on CT, or researching Solana NFTs, he likes to read about psychology, InfoSec, and geopolitics.