If you've tried your hand at investing in crypto interest accounts, you've probably seen the interest rate mentioned in terms of APR, APY, or both. Crypto platforms often use these terms interchangeably, even though they aren't. They can significantly affect how much is paid back for personal loans or the interest generated on a savings account. But when considering these platforms, what are these terms in essence, and how do they work to help you manage your crypto assets?

What are APR and APY?

Non-crypto investors are likely to see the terms APY and APR in different places. Annual percentage yield (APY) refers to the rate of return on investment when compounding is taken into account. On the other hand, the annual percentage rate (APR) is the return you get on investment without compounding, also known as the simple interest rate. Even though this seems like a simple comparison, the words can be hard to understand, especially when you think about how they are usually used.

Financial institutions typically use APR to sell their credit-based products, such as personal loans, since it seems that the borrower is paying less in the long run. Investment companies usually use APY to sell their investment accounts since it appears to the client that their rate of return will be higher after a year. Depending on the compounding frequency, this could indeed be true. Financial institutions use a rate per period to figure out interest, and this interest is added up over the course of a year.

Depending on the bank that holds the account, most crypto savings accounts add interest daily, weekly, or monthly. Here's a list of platforms that pay compound interest.

The Differences Between These Interest Calculation Methods

It may not be immediately obvious how different these methods used to calculate interest are. However, the difference in final returns is significant and can change a person's outlook on a particular investment.

APR deals with simple interest. The calculation for simple interest means that the amount earned remains the same for any given year. The interest calculation doesn't consider any new profit added to the account. APY takes into account the extra interest earned and gives a better return on investment overall. With each passing year, the amount of interest a person acquires will increase exponentially. APY is the most common way that crypto savings earn money, but some companies still offer simple interest on their accounts.

It's easier to demonstrate this difference with real numbers. Let's say investment companies offer a 1% APR on a deposit. We deposit $1,000 in the account. After a year, the simple interest our investment generated would be:

I = Deposit x Rate x Time
I = 1000 x 0.01 x 1
I = 10 BTC

After a year, we'd get 10 bitcoins off of our 1,000-bitcoin investment. However, this rate remains constant. The following year, we'll only get 10 BTC as returns since the calculation doesn't involve the new interest added to the account. After a five-year investment, we'll have received 50 BTC as interest on the account.

Conversely, compound interest calculations for annual percentage yield are a bit more complicated. The calculation in this case involves the following:

Amount = P(1+rate/number of periods)^(number of periods x time)

So, taking our initial 1,000 BTC investment with a 1% rate compounded monthly, we'll get:

A = 1000(1+0.01/12)^(12x5)
A = 1000(1.000833333)^60
A = 1051.25 BTC

At this rate, the difference does not appear to be significant. But as the compound interest rate goes up, the difference between APR and APY becomes more important. APY is an exponential formula. It allows a person to build on what they've earned in the past. They can then use those earnings as a springboard to increase their income. With interest compounded monthly, an investor could earn quite a bit from their money market account. With an annual percentage rate of return, an investor gets a straight amount from their deposit, regardless of how much that deposit has grown. The annual interest rate only looks at the principal balance, not the amount within the account, when it calculates interest. The interest accrued from year to year is constant once the deposit remains constant.

Why Should I Pay Attention to Apr and APY?

Personal finance enthusiasts would spend a long time explaining why these two terms are so important for proper money management. The simplest explanation is that the annual percentage yield and annual percentage rate both play a massive part in how you earn interest on your deposit accounts. Using these formulas, it's easy to figure out how much interest a certain account earns. However, it's essential to figure out whether the financial institutions you're dealing with correctly use these terms.

Compound interest rates should be reflected as APY, while simple interest rates should be shown as APR. Each of these will determine how much interest a particular account will earn over a year. The monthly payments your crypto assets generate will increase over time if they're in a savings account. In a traditional bank account, it's less common to get compound interest.

Is It Safer to Put Money in a Bank?

The truth is that bank accounts often don't offer clients compound interest on savings. Instead, the interest rate they quote solely deals with APR. Traditional institutions also provide much lower interest rates on deposits than cryptocurrency accounts. This approach is partly due to the consideration of inflation. Interest rates at these banks need to take inflation into account. To determine the actual interest rate that one earns on their account, one must look at the nominal interest rate. Deposit insurance makes sure that the person who puts money in the bank will get their money back if the bank fails.

Since many platforms don't offer deposit insurance, investing money in a crypto savings account is a little riskier. But the interest that builds up in these accounts can help investors make a lot of money. As time goes on and the interest builds, the returns can quickly make traditional banks seem less safe. People who put their crypto assets in an institution can even borrow money from that institution, which increases their chances of making money from their holdings. One cannot earn significant gains without a certain level of risk. Crypto savings offer investors the best returns while still giving them peace of mind and security.