Annual percentage yield, or APY for short, serves as a fundamental metric for evaluating returns on your investment.
Initially invented in traditional finance, this index serves just as fine for crypto investors. It helps to estimate the annual actual interest that one may earn. Moreover, it covers the compound interest that increases together with the overall balance.
With TradFi, APY applies to such methods of growing your wealth as certificates of deposit, savings accounts, government bonds, etc. Blockchain-based solutions, in turn, come with a much broader variety of solutions for making passive income. But most importantly, they offer much higher APY to their users.
Read this article to find out what APY in crypto is, how to calculate it, and what methods can help you boost your profits.
What Is APY?
As mentioned earlier, APY is an abbreviation that stands for annual percentage yield. This is a standard method to calculate the real rate of the returns that you get on your investment within one year.
In TradFi, this metric helps to estimate your profits when earning interest through savings accounts or other types of bank deposits.
APY in crypto works similarly. Also, it considers compound interest which is quite a common way of making passive income in this area. Compound interest refers to the interest you earn on your initial deposit plus the interest you make on the previously accrued interest.
In addition, the blockchain industry offers a huge variety of earning opportunities. At the same time, the entry threshold is much lower in comparison with TradFi. Investors may deposit their coins into different protocols and watch their savings grow daily.
Combined with lucrative crypto rewards, earning APY in crypto is an interesting option to consider if you want to boost your profits and diversify your portfolio.
APR vs APY in Crypto
APR (annual percentage rate) is another helpful index reflecting the interest that you earn from the deposited sum per year.
The Consumer Financial Protection Bureau (CFPB) defines APR as the annual percentage rate that you pay for borrowing money. Applied to crypto, the term has the same definition.
While it may seem identical to APY at first glance, there is still an important distinction. Unlike APY, APR is more straightforward as it doesn’t take into account the compounding interest. Also, APR covers all the fees that the borrower pays while taking a loan.
Thus, with all other input data remaining the same, APY will always be higher due to the compounding effect.
Check a short comparison table below to get a structured understanding of how APY differs from APR:
| Annualized Percentage Rate (APR) | Annualized Percentage Yield (APY) | |
| Interest is compounded | No | Yes |
| To whom it is most applicable | Borrowers | Lenders or investors |
| The size of the annual yield | Lower | Higher |
How To Calculate APY
The formula for calculating APY is pretty simple:
Where
r = annual interest rate
n = number of compounding periods per year
1 = representation of the initial investment
Let’s review three basic examples of how to calculate APY in crypto.
Assume, you stake 1,000 tokens for 1 year with 12% annual interest. The scenario may be as follows:
APR. To calculate APR, you need to take the flat rate and simply apply it to your deposit at the end of the staking period. Thus, it will make up 120 tokens.
APY compounding monthly. By putting these numbers into the formula (r = 0.12 and n = 12), we will get an APY of 12.68%. That will mean a total return of 126.8 tokens.
APY compounding quarterly. In this case, the number of compounding periods is reduced to 4 which will affect the final payment. The formula above will result in 12.55% APY or 125.5 tokens.
Many crypto interest-earning services may try to lure users with high APYs. However, you should always make your own calculations before entrusting your funds to any third party. Use the formula above to estimate the potential rewards that you may get while taking into consideration the metrics that such services speculate upon.
How To Earn APY on Crypto
In a nutshell, there are four basic methods: staking, crypto savings accounts, lending, and yield farming. We will give a short review of them all below.
Staking
Applied to the blockchain, staking refers to the process where users lock up their cryptocurrency holdings to validate transactions and secure the network. In return, they earn rewards for their contribution.
Initially invented as an energy-efficient alternative to the proof-of-work (PoW) consensus mechanism, staking is available on proof-of-stake-based (PoS) networks. In such networks, the choice of a validator and, consequently, the size of the reward depends on the number of coins at stake.
In fact, one may compare staking in crypto with depositing funds in a bank. Just like banks use the funds to generate profits and provide interest to depositors, PoS networks share rewards with participants who stake their assets. These rewards serve as an incentive and allow stakers to earn passive income.
Thus, staking enables crypto holders to earn passive income on their coins. To do that, you may lock up your assets in a staking address and contribute to the consensus as a validator or delegator. In this situation, the annual percentage yield (APY) represents the expected annualized return on your staked coins.
On some blockchains (like Cardano), staking rewards automatically compound, while on some other blockchains (like Avalanche) rewards don’t compound meaning the APY would be the same as the APR.
What factors influence APY in staking?
Factors influencing the size of the APY include the specific characteristics of a given network such as inflation rates, etc.
The commission fees charged by the platform or validator, the total amount of coins staked on the network, and the emission schedule have their say as well.
Crypto Savings Accounts
Crypto savings accounts offer another opportunity to earn passive income by keeping your cryptocurrency in a specific deposit address.
They function similarly to traditional savings accounts offered by banks but offer potentially higher returns. While banks typically offer no more than 1-2% APY, crypto savings accounts can provide much more lucrative rewards.
Typically, crypto savings accounts are available on centralized crypto exchanges. In this case, users deposit their cryptocurrencies while the exchange acts as an intermediary investing these funds in various ways.
The rewards are generated through other investment opportunities that the platform investigates on its own. Some of the most popular sources include investing in other crypto projects, staking assets, or lending assets to other users.
What factors influence APY in savings accounts?
There are two basic types of crypto savings accounts that have an impact on the APY that you may expect to earn:
Flexible accounts. Users may withdraw their funds at will whenever they want to. While this option is quite convenient, it results in lower APY.
Fixed accounts. In this case, the rewards are higher. However, funds in these accounts have to be locked for a predefined period. Users cannot access them during that time and they may lose other opportunities that arise on the market.
Lending
Crypto lending represents a type of financial service that allows individuals to lend their cryptocurrency holdings to borrowers in exchange for interest payments. Thus, it provides an opportunity for crypto holders to earn passive income on their idle assets. At the same time, borrowers get access to crypto funds without the necessity to sell their own holdings.
To get a crypto loan through such a service, one has to deposit crypto collateral. In case of the borrower’s insolvency, this collateral may later be used to cover the debt.
Lenders, in turn, share their crypto assets with those who need them and earn steady rewards in the form of interest.
What factors influence APY in lending?
When it comes to lending crypto, consider the following factors that may influence your APY:
The digital asset. Different cryptocurrencies have varying APYs on different crypto lending platforms due to different levels of supply and demand.
Platforms and interest rates. Each platform sets its own lending rates which you may compare to find those with competitive rewards.
Supply and demand. Higher demand for borrowing specific cryptocurrencies results in a deficit of coins in the protocol and, therefore, it can increase lending APY.
Loan terms and risks. Consider loan duration, collateral requirements, and associated risks before participating in lending.
Yield Farming
Yield farming, also known as liquidity mining, is a way to generate returns or rewards by providing liquidity to decentralized finance (DeFi) protocols. It involves placing your cryptocurrencies in automated market-making (AMM) pools, which facilitate trading on decentralized exchanges.
Distributing tokens through yield farming solutions is the best fit for new projects. Since newly created startups often lack liquidity, they may create liquidity pools and incentivize users to support them with lucrative rewards.
On the contrary, farms that feature more stable and predictable cryptocurrency pairs such as BTC/ETH or ETH/USDC offer higher stability. Yet, the rewards they offer are usually lower.
At first glance, it may seem pretty similar to staking. Indeed, these two terms are often treated equally, but they are not entirely the same. While the goal of staking is to support the network, liquidity mining aims to support traders.
What factors influence APY in yield farming?
When it comes to generating APY through yield farming, there are a few aspects to keep in mind:
Impermanent loss. Carefully estimate the potential impact of value fluctuations on your APY and be prepared for potential losses.
Market conditions. Stay informed about market trends and platform updates to optimize your yield farming strategy.
Security aspects. Evaluate the security measures and reputation of platforms to minimize risks. Thorough research is key to making informed decisions for a favorable APY.
Things To Consider About APY
In addition to the factors influencing APY, there is a number of aspects that you should consider if you decide to stake your assets or select any other means of making passive income in crypto.
Look out for the following indices to evaluate APY and, consequently, your potential ROI.
Compounding Periods
In the case of compound interest, the frequency of payouts has a direct influence on the size of your earnings. The higher the number of compounding periods, the higher APY.
Therefore, this information is crucial at the research stage as it may help you estimate how much you can earn. If a crypto-earning service doesn’t publicly reveal this information it would be difficult to estimate its real rewards.
Let’s refer to the example and the formula that we’ve reviewed above to understand how it works.
With 1,000 tokens being staked for 1 year with 12% annual interest, the size of your earning will be as follows.
With monthly payouts, APY = (1 + 12%/12)^12 - 1 = 12.68%
With weekly payouts, APY = (1 + 12%/52)^52 - 1 = 12.73%
As you may see, the crypto earnings product that offers weekly payouts provides higher rewards than the one that compounds interest monthly. Thus, an investment of the same size will result in different APY with different numbers of compounding periods.
Investment Duration
Typically, crypto-earning services offer investing solutions with different durations. Some of the most common scenarios involve staking your coins for 1 week, 1 month, or 3 months.
However, the period of investing doesn’t have any impact on the APY per se. In the formula above, the duration of investment is nowhere to be found. It’s the compounding frequency that plays a key role.
Yet, the services themselves may offer different rewards depending on whether you choose to invest your assets on fixed or flexible terms.
The risk when investing in crypto for a fixed and long period of time is much higher. Therefore, the APY that such packages come with is higher as well.
Variable vs Fixed APY
Another important aspect to consider is whether APY is fixed or variable.
It’s easy to guess that a fixed APY doesn’t change over time. A variable APY, on the contrary, may alter in accordance with the market conditions or any other aspects that a given service deems important.
Let’s review the following example to understand how variable APY works.
Assume, a crypto lending service offers a 5.5% and 7% APY for borrowing ETH at a fixed and variable rate respectively.
If you select the first option, you will have to pay a flat 5.5% on your loan regardless of the market conditions. Even if the ETH price significantly spikes all of a sudden, the fixed rate will help you mitigate the impact.
Variable rates, on the contrary, change together with the ETH price and its trading volume. Thus, the spike in assets’ prices may drive the borrowing rate up to 8% or even higher. The opposite scenario is also possible, though.
Aave is a good example of a crypto-earning service where borrowers may choose between fixed and variable rates. The latter change together with the supply and demand on the platform and so does investors’ APY.
APY vs Risk
The level of risk is another factor that has a direct influence on APY in crypto.
For example, Kucoin offers more than 100% APY for some of the assets within its Kucoin Earn product. However, such high returns are only available with dual investments which are not principal-protected products.
The primary source of risk for such products comes from potential changes in the prices of these assets. The chances for good rewards and high losses may be more or less equal in the conditions of a highly volatile market. Therefore, you should thoroughly assess your tolerance for risk before engaging with such products.
Supply and Demand
Just like in traditional finance, the supply and demand ratio has a high influence on the crypto market in general and on crypto lending services in particular.
As the demand for crypto loans grows, so does the interest rate and, consequently, APY that lenders may expect to earn. On the contrary, with sufficient supply, the rates tend to decrease.
Another example of how supply and demand affect APY refers to newly-launched projects. To attract capital, they usually offer higher APY within their crypto-earning products. As time passes and these projects gain full strength, their demand for funding decreases as well as the interest rates.
Price Volatility
Finally, the high volatility of the crypto market, in general, may have a significant effect on your earnings when you convert them into fiat.
You may earn 100% on your crypto assets within a couple of months and then lose it all as the asset price drops below any reasonable limits. Vice versa, even minor earnings may be substantial upon the cashout if the asset’s price spikes.
Stablecoins like USDT or USDC offer quite predictable returns on investments. However, the rewards that crypto-earning products offer are usually much lower in comparison with volatile assets. Therefore, you should once again identify how high your tolerance for such risks is.
Final Thoughts
APY is a nice index that is worth considering if you decide to make passive income via any of the crypto-earning products.
However, do not blindly trust the numbers that these products display on their websites. Keep in mind different factors that influence APY and always do your own research before you entrust your funds to any third party.
