One of the most attractive aspects of cryptocurrency investing is the potential to receive a high APY (Annual Percentage Yield). This is often done through decentralized finance (DeFi) services or cryptocurrency exchanges.
The interest rates which many of these DeFI and cryptocurrency platforms give to users is far higher than they would be able to get through traditional avenues such as a high interest savings account at a bank. However, it is likely that you have seen APY and APR mentioned by different services. What is the difference? What is APY and how does it work in crypto? Are returns really as high as stated? We will take a look at all of that in this guide to understanding APY in crypto.
What is APY?
Annual percentage yield, or APY, is the realized rate of return earned on an investment. It takes into account the effect of compounding interest.
Compound interest is automatically added to the principal balance periodically which increases the total amount interest is being earned on. Over time this results in greater returns than APR because the total deposit invested increases.
What’s the Difference Between APY and APR?
Annual percentage rate, or APR, is the rate earned over the whole period without taking compounding interest into account.
APR uses simple interest, meaning the earned funds do not automatically get added to the principal. The only real difference between the two types of interest rates is that distinction between compounding and simple interest.
Why Do Some Platforms Use APR and Some Use APY?
Banks, financial institutions, and crypto platforms all use APR and APY interchangeably in order to make a rate for borrowing seem attractive, or a rate for lending attractive.
Borrowing services typically tout the APR they will charge because it does not take compound interest into account, which makes it look like a lower fee. It would likely scare away many borrowers if they knew just how high the interest could get if they did not pay off the principal within the allotted time.
Lending services tend to tout the APY they offer for the opposite reason: it makes the interest rate that the lender will get for supplying an asset look much more attractive. It helps attract many investors because the number is higher than it would be as an APR. However, many crypto lending services will tell you an APY but will not actually be compounding your interest themselves. This means that unless you manually compound your interest then you will just receive the APR and none of the benefits of compounding interest. DeFi services and crypto exchanges often have auto-compounding options and simple interest options.
How APY Works for Crypto
APY in crypto works a little differently than traditional finance. This is because instead of receiving an interest rate based on the dollar value of your holdings, you receive an interest rate based on the amount of asset supplied. For example, if you were to get 5% APY and deposited 1 Bitcoin, you would get 0.05 BTC in interest after one year. The value of Bitcoin does not affect the interest rate you receive. This can make crypto APY far more attractive than traditional investment options. However, as stated earlier, platforms will state an APY but may not actually be compounding for you.
There is something else to take into account when looking at APYs in crypto, and that is impermanent loss. The highest APYs you can get for crypto are always for liquidity pools, where users deposit two assets in equivalent dollar amounts in order to receive rewards from transaction fees. When using these liquidity pools, it is likely that you will experience some impermanent loss, however, as long as the interest rate you receive outweighs the loss, it is still a worthwhile investment.
What to Expect in Returns for Crypto
As mentioned in the previous section, the returns you receive for crypto are based upon the amount of the asset you supplied. This can result in extremely high returns if the asset goes up in value in conjunction with receiving compounding interest.
The main thing to note is that for many DeFi services, the rate will go down over time, as more users add their assets to the pool. Many of these services also have a higher payout in the beginning to attract interest before tapering it down to realistic figures. When liquidity pools first launch, they always have extremely high APYs because there is very little asset supplied. That APY can drop exponentially in a matter of minutes depending on how fast liquidity is added by users.
When using centralized services such as Crypto Earn, it is just as possible for the interest rates to decrease over time, but it is less easy for them to just change it without warning, as they have regulations to follow. This means that the interest rate may drop from 5% to 3%, but it will be done as a change after a term, rather than on the fly which is the case with DeFi.
Generally speaking, a typical return for crypto assets on an exchange is between 2-15%, with the higher end of that spectrum being for stablecoins, and the lower end being for extremely popular assets such as Bitcoin and Ethereum.
For DeFI services like liquidity pools the rates can be much higher than that, but as aforementioned, the rates are likely to drop fairly quickly. That being said, it is possible to take advantage of something like 1000% APY for a short period of time before it drops down to normal levels as users add liquidity. For more stable DeFI services such as vaults, the interest rates are about the same as through an exchange but can also be lower if there is a lot of supply and little demand for the asset to be borrowed.
Overall, expect to receive higher returns than a traditional savings account or bond, but do not expect ridiculously high interest returns to last too long when they are available.
