Learn how to maximize your returns in DeFi by understanding the difference between interest, APR, and APY.
All investors, hedge funds, venture capitalists and the average retail investor in cryptocurrency and Decentralized finance (DeFi) have a desire to increase the return they make on their investment in a safe and fast way. To do this they must seek out the highest APR and APY that fits within their risk appetites.
However, in DeFi, the learning curve is steep making the barriers to entry higher than that of traditional finance. There is a lot of complex terminology and buzz words used. And even worse, very often terms like Simple Interest, APR and APY are mixed up and even inaccurately explained and calculated.
The aim of this article is to explain how Simple Interest, APR and APY work in both traditional finance and in Decentralized Finance (DeFi). You will learn how to calculate them and how they impact both borrowing and lending. By understanding these basic financial functions and improving your financial literacy skills you will be on your way to making better financial decisions when you interact with DeFi product like Liquid pools, yield farming, lending, and borrowing.
It is worth pointing out at this early stage, when calculating a return on investment in DeFi, be it APR or APR, very often projects use their native token in their calculations. This can often be misleading as the users of the platform may have no interest in the platform token and these tokens can often devalue rapidly, reducing the return an investor was expecting. It is also a nightmare when platforms use APR and APY interchangeably which is totally inaccurate. Therefore, investors need to take the time to understand these concepts and be able to understand the offering from the DeFi Platform they wish to engage in. In crypto especially, it is your responsibility to understand the details and terms of any investment.
Interest is basically a fee on leading or borrowing. You pay interest when you borrow money, you earn interest when you lend money. What makes it complex is how the interest is calculated and what’s included in the calculations. Sometimes interest is calculated with other fees such as a loan setup fee, sometimes interest is calculated on the principle only and sometimes interested is calculated on the principle, plus any interest already earned.
In the fiat world, base interest rates are set a controlled by the likes of the governing council of the European Central Bank, or the Federal Open Markets Committee (FOMC) in the USA. There are many factors that go into determining an interest rate including the employment levels, inflation, spending and so forth.
Banks then use a combination of the base rate and personal credit score, income levels, payment history and other personal factors when they are determining the rate of a loan to the likes of you or me. The riskier the loan, for example a loan to someone with a bad credit score, then the higher the interest the bank will charge. This is because they banks take on more risk with someone carrying a bad credit score and with higher risk are higher rewards.
DeFi is very different to this. Investors have the same access to rates when then borrow or lend no matter what their credit score is, or the income levels or even their geographical location. DeFi makes finance a more level paying field when it comes to accessing finance and earning a yield.
Simple interest likes its name is the easiest type of interest to calculate. However, is it the least use form of interest calculation out there.
The formula is:
Interest = Principle * Interest rate * Time
To calculate simple interest, we must know the principal amount. This is the amount of the initial investment or borrowing. We must know the interest rate and we must know the term of the investment or borrowing.
Let’s say you invest $1000 into DeFi. The funds will be locked up for a year and the interest rate will be 4%
We can say then that:
Principle (P) = $1000
Interest rate (R)= 4%
Time (T) = 1
So, interest = $1000 * 4% * 1 = $40
At the end of the year, or lock up period, you would have €1040.
If we put this into a spreadsheet, our principle in cell D3, interest rate in cell E3 and time in cell F3, our formula for simple interest would be =D3*E3*F3
APR stands for Annual Percentage Rate and it is the yearly amount you will be paid in interest for an investment, or the yearly amount that you will pay in interest for a loan. In traditional finance, this includes any other costs included such as broker fees and other costs included with setting up and closing the loan or investment. APR is higher on borrowings than simple interest because it includes these extra costs. Whereas simple interest is often higher than APR on investments as the costs are not included in simple interest.
In DeFi, most platforms do not include other costs as part of the APR calculation. This is because fees such as gas fees used to pay for the transaction are borne by the use and can vary greatly depending on how busy the platform is at the time of the transaction.
To add to the complexity, the gas fees are often not the same token as the platform token and fluctuate in price against the platform token. Therefore, the user needs to be aware of their cost of entry and exit from a DeFi protocol or platform.
In traditional finance, APR is most often use for borrowing and loans. In DeFi it depends on the platform.
Let’s say you invest $5000 at an APR of 4% for a term of 3 years. How much would you have at the end of the first, second and third years.
Year 1: Interest = $5000 * 4% = $200. Balance at end of the year is $5000 principle + $200 interest earned = $5200.
Year 2: Interest = $5200 * 4% = $208. Balance at end of the year is $5200 principle + $208 interest earned = $5408.
Year 3: Interest = $5408 * 4% = $216.32. Balance at end of the year is $5408 principle + $216.32 interest earned = $5624.32.
If we put this into a spreadsheet with Principle in column D, interest rate in column E, then the interest will be D * E. The balance at the end of the year will be D + E.
To calculate APR, you need to know the principal amount, the interest rate, any other fees, and the number of days in the term.
Let’s say you invest $1000 into DeFi. This could be by adding funds to a liquidity pool on a DEX or adding funds to a lending platform. The funds will be locked up for a year and the interest rate will be 4%. There is also a gas fee to pay the final cost of these were $10 worth of Ethereum to enter the investment and $8 to exit the investment.
The formula is.
APR = ((Interest - costs / Principal / Number of days) x 365) x 100
APR = ((I-C /P /N) * 365) * 100
Let’s first calculate I, which is the interest. We know the principle is $1000 and the interest rate is 4% so the interest earned will be $40.
Next, we can work out the total other costs. When doing something on the blockchain we must sign a transaction with our wallet, which will incur gas fees, and we have been told that we paid €10 to sign the transaction on the way into the protocol and €8 to sign the transaction when we exit the protocol. The total cost is therefore $10 =$8 = $18
The number of periods is calculated daily. As the investment period is a year, the value for N is 365 days.
When we apply these values to the calculation, we then multiply by 100 to convert the decimal to a percentage.
Let’s look at all that now!
If APR = ((I-C /P /N) * 365) * 100
I - C = $40-18 = $22
I-C/ P = $22/$1000 = 0.022
/ N * 365 = (0.022/365) *365 = 0.022
*100 = 0.022 * 100 = 2.2%
The APR for this investment is 2.2%, considerably less than the interest rate. When using DeFi, if the APR rate is shown on the protocol, then you need check the documentation to see how the APR is calculated. Most often, if APR is being used as a metric by the protocol, it does not include the gas fees you will pay, and this will have an impact on the actual return.
In traditional finance APR is generally used more for Borrowings and loans than investments. It is evident from the above calculation that the APR on Investments is less than the interest rate and not so likely to attract customers. However, when APR is calculated on borrowings a truer reflection of the cost to the customer.
Let’s say you borrow $1000 from a DeFi protocol. The funds will be borrowed one year, and the interest rate will be 4%. There is also a gas fee to pay the final cost of these were $10 worth of Ethereum to borrow the funds and $8 to repay the funds.
The formula is.
APR = ((Interest + costs / Principal / Number of days) x 365) x 100
APR = ((I+C /P /N) * 365) * 100
Let’s first calculate I, which is the interest. We know the principle is $1000 and the interest rate is 4% so the interest due will be $40.
Next, we can work out the total other costs. When doing something on the blockchain we must sign a transaction with our wallet, which will incur gas fees, and we have been told that we paid $10 to sign the transaction on the way into the protocol and $8 to sign the transaction when we exit the protocol. The total cost is therefore $10 =$8 = $18
The number of periods is calculated daily. As the loan period is a year, the value for N is 365 days. When we apply these values to the calculation, we then multiply by 100 to convert the decimal to a percentage.
Let’s look at all that now!
If APR = ((I+C /P /N) * 365) * 100
I - C = $40+18 = $58
I-C/ P = $58/$1000 = 0.058
/ N * 365 = (0.058/365) *365 = 0.058
*100 = 0.058 * 100 = 5.8%
The APR on this loan for one is 5.8%, higher than the simple interest rate, as it includes costs. If this loan was for 2 years instead of 1, the APR will reduce, as the interest is over 2 years, which doubles the amount from $40 to $80. The only other change in the values of the formula would be N = 365*2 = 730
I - C = $80+18 = $98
I-C/ P = $58/$1000 = 0.098
/ N * 365 = (0.098/730) *365 = 0.049
*100 = 0.049 * 100 = 4.9%
Banks, lenders and DeFi protocols may have different ways of calculating APR. Anyone borrowing under APR terms should read the documentation to find out what is included in the APR. For example, as we have seen, protocols do not include blockchain transaction fees in the APR and banks often exclude early full repayment penalties on fixed loans in their APR calculations.
Rates can be fixed or variable. Variable APR will depend on things like the base rate issued by the ECB or FED. Fixed rates are based on things like the banks longer term borrowing rate and not shorter terms changes. Of course, credit score and personal information are also used to determine risk.
APR does not include the power of compounding as this can really impact the interest on investment or loans taken out for a longer period.
In DeFi, people are attracted to high returns, but many people underestimate the risks. The higher the return the more risk you are taking. This risk is often in the form of the protocol token from which the yield is derived.
APY is the Annual Percentage Yield, or the amount paid in interest for a year including costs and including compounding. In traditional finance, generally APY is used for lending and investing, where APY is used for borrowing.
Compounding is the frequency, or the number of times during an investment period that interest is applied. The higher the frequency the higher the return. Understanding Compounding is one of the greatest ways to grow your wealth and is something you should explore further. We have a full Crypto Bite The Power of Compound Interest - Financial Literacy Skills for DeFi, it will take you about 20 minutes to complete, after which, you will have gained not only knowledge but also 2000 XP and a NFT certificate of learning.
Think of compound interest as a magic potion you pour onto your savings. At first, it works slowly, but with time, its effects become increasingly powerful. The more you apply it (time passing), the more it enhances your savings (compounding). Over time, your savings turn from a small flask into a bubbling cauldron of wealth. This is because interest is not only applied to the principle, but also to any previous interest earned. To truly understand the power of compounding, you must really complete that crypto learning bite.
To calculate APY we need to know the period interest rate, and the frequency of compounding. The period interest rate is the interest rate per compounding period.
For example, let’s say the annual interest rate is 4% and compounding happens 4 times a year, then the period interest rate will be 4% / 4 = 1% per compounding frequency. If the annual interest rate is 4% and compounding is daily, then the period interest rate will be 4% / 365 = 0.01%
The formula for calculating APY can be expressed as
APY = (1+ period interest rate) no of compounding periods -1
APY = (1+R) N-1
Let’s say you invest $1000 with an interest rate of 4% and compounding will happen 12 times a year, at the end of each month. How much will you earn in interest at the end of the year and what will your final balance be?
We know the frequency is 12 times per year and the annual interest rate is 4%. Using these values, we can calculate the period interest rate. 4% / 12 = 0.33%
Applying these values to our formula,
APY = (1+R) N-1
APY = (1+ 0.0033) 12-1 = 0.04074
Convert 0.04074 to percentage by multiplying by 100 = 4.074%
Interest earned = $1000 * 4.074% = $40.74
At the end of the year, you would have a final balance of $1040.74.
As you can see this is higher than the simple interest of 4% however APY does not include fees and is also higher than APR.
Everyone struggles with this calculation at the start, so you are not alone if that example did not make to much sense. But once you complete the learning bite, you will fully understand this concept.
Let’s say we invest 5000 paulacoin, a native token on a protocol. The APY is 20% and the compounding is automatic every 6 hours. We invest this amount when the value of paulacoin is $2 and the investment period is 6 months.
If the protocol is compounding every 6 hours, then it is compounding 3 times a day or 3 * 365 = 1095 times a year. If our investment is for 6 months, we will have a total of 1095 / 2 = 547
The period interest rate will be 20%/1095 = 0.018%
Using our formula APY = (1+R) N-1 we can say
(1+.00018)547-1 = 0.1051
Convert to percentage = 100 * 0.1051 = 10.51%
At the end of the 6 months, we would have 5000 * 10.51% = 525 paulacoin in interest and a new balance of 5525 paulacoin, that’s not a bad accumulation right!
In this example the APY is calculated using the native token quantity staked, and not the $ value of the native token. This is because the $ value would be volatile which would make it difficult for a protocol to keep a steady APY.
Taking the above example, let’s say the value of paulacoin is only $0.50 at the end of the 6-month period. Our initial investment was valued at $2 * 5000 = $10,000. Our investment value at the end of the investment period is $0.50 * 5525 = $2762.50. That’s a substantial loss of 72% on our fiat investment. In DeFi, this is often the trickery used when a protocol is not being clear, concise, and consistent with how it represents its reporting returns. Because the platform is either misleading or the user has not done their research many people get tricked into accumulating tokens that just depreciate, and the value of their investment gets washed away.
DeFi users should always read the protocol documentation and understand how the protocol charges users, and how they calculate rewards, how often they compound, and the user should be able to calculate the different returns for themselves.
DeFi users should also be aware that many protocols do not automatically reinvest profits for auto compounding, and users will pay extra transaction fees when manually compounding. This can have an impact on the final return.
It is important for DeFi users to not only understand the rewards, but also the risks. Risks do not only include financial risk tolerance, but also security risks such as smart contract vulnerabilities or possible bad actors working within the team.
In traditional finance users should also read the documentation. Very often interest rates change, for example, a credit card company might offer you an attractive discounted APR, however after 3 months this could increase. Traditional finance finds ways to burn customers, just like bad actors in DeFi.