What is APY?
APY (Annual Percentage Yield) reflects an annual rate of return — the yearly amount you’ll be paid in interest — for your original investment and regularly compounded interest. APY is generally the term used for lending and investing, whereas APR is often used for the context of borrowing.
The frequency at which the interest is compounded changes based on the platform or organization. Compounding can be monthly, weekly, daily — it’s entirely up to the platform the investor chooses to interact with. The faster the compounding, the higher the return over time.
Think of APY like a snowball rolling down a mountain. As the snowball (original investment) rolls down the hill (time), more snow accumulates (interest) and the snowball becomes exponentially larger (compounding).
A more frequent rate of compounded interest amplifies the difference between the APR and APY.
If the snowball rotates at a faster rate down the hill, it naturally would gather more snow and grow larger, faster. We can think of compounding interest in the same way.
This same impact can be applied to borrowing, too. Borrowers with credit cards, personal loans, mortgages, etc. that have interest will also experience the compounding effect of their debts. It’s important that borrowers be mindful of this when considering loans and the impact on their finances over the long term.
How to Calculate APY
To properly calculate APY, a borrower needs to know: the period rate and the number of compounding periods based on the terms.
A popular formula for calculating APY can be shown as:
APY = (1 + r/n)-1
Where, in our formula:
- r equals the periodic interest rate
- n equals the number of compounding periods
The component that creates such a distinction between APR and APY is the “n” value in APY’s formula, as this reflects the frequency of compounding interest. The higher the frequency of compounding, the larger the difference between APR and APY.
Let’s assume we have a savings account with $10,000 that earns an annual interest of 5%. This means we’ll earn $500 after a year, totaling $10,500.
Let’s look at how much we’ll earn if our interest compounds every month. We can do this by updating our formula:
APY = (1 + r/n)-1
APY = 1 + 0.05/12)12-1 = 0.051162…
Convert 0.051162 to percentage (x100) = 5.1162%
Multiply the principal by APY% to determine result: $10,000 x 5.1162% = $511.62
At the end of the 12 month period, your $10,000 investment would now be worth $10,511.62 — the compounding impact of APY would earn an additional $11.62.
This may seem like a small instance, but this can have dramatic effects for investors over longer periods of time.
How Might This Look in DeFi?
Let’s assume our friend Satoshi invests 10 Bitcoin (BTC) into a DeFi platform. The APY for Bitcoin lending is a whopping 20%. Satoshi decides to leave his 10 BTC in the platform for a full year.
Let’s assume the DeFi platform compounds every month; 12 times a year. During each recalculation, the interest is added to the original investment amount and the subsequent month period builds on the prior’s sum.
Based on our APY calculation, Satoshi’s formula for 10 BTC looks like:
10 Bitcoin x 1 year x 12 rebalancing periods (months).
APY = (1 + 0.20/12)-1
- Step A: (1 + 0.016667)12-1
- Step B: (1.016667)12-1
- Step C: 1.21939588252-1
- Result = 0.21939588252
Multiply x 100 to get Percentage (%) = 21.939%
10 x 21.939% = 10 x 0.21939 = 2.1939
Satoshi’s starting Bitcoin = 10 BTC
After a full year, Satoshi will have earned = 2.1939 BTC
Satoshi’s final Bitcoin balance = 12.1939 BTC
APY earnings (2.1939) vs. APR earnings (2).
How to Consider Choosing DeFi Products
We cannot stress enough the importance of doing as much research as possible before moving funds into a DeFi protocol and interacting with their smart contract(s).
There are many factors at play, but a few basic thoughts to keep in mind when determining if a DeFi platform is right for you include:
- their fees (and clarity)
- their community
- their team
- their contracts/code
- their reputation
- their APR / APY rates
- their documentation
An Important Note for DeFi Investors
While a DeFi project may show APY, the user may be responsible for gathering and reinvesting the rewards (interest) back into the protocol. Meaning, the effort of compounding may fall on the DeFi investor. Always be sure to research DeFi projects to truly understand the inner workings before interacting with the platform.
Many DeFi products to not automatically reinvest interest/rewards, which is why auto-compounding services like, Beefy Finance, Autofarm, or Reaper Farm, are quite popular. These products will handle the reinvesting/compounding for you for a small fee. This saves DeFi users and investors a great deal of time. It’s worth noting, however, that using additional projects ads a layer of security risk due since there are more smart contracts being used on a regular basis.
There can be a frustrating lack of clarity in DeFi with regards to APR and APY listings. They can be – and sometimes are – incorrect or misleading. Regularly, the APR or APY will include that DeFi protocol’s native token as part of the rewards.
This can be misleading for a number of reasons. One reason is that it can mislead investors into expecting returns higher than what they receive. Second it’s not always clear to the investors that some of the APY includes the protocol’s token, which may be of no interest to the investor and may indeed have very little value at all. Investors should take the time to understand if a DeFi product is incorporating native tokens or fiat value as the standard of return in their offering.
Worse, however, is the occurrences where some DeFi platforms use APR and APY interchangeably, which is — as we’ve learned — simply inaccurate. Understanding the principals of, and mathematics behind, interest, APR, and APY can help lenders, borrowers, and investors have more clarity in their financial experience.
No matter the platform, investors and users in both traditional and decentralized finance products must take care to understand the details and terms of any investment.