If you’re into crypto, you’re probably here because of the potentially higher gains than other investment assets can offer.
The space offers numerous ways to increase your cryptocurrency holdings.
Annual Percentage Yield (APY) is one of the methods every crypto investor should know about if they want to understand how their money grows.
What Is APY?
Annual Percentage Yield (or APY) is the total amount of interest that you may earn on your cryptocurrency balance over one year.
The key feature of APY is compound interest, calculated each month. This means that you earn returns on both the initial investment amount and the interest you’ve accumulated every month. Basically, it is earning interest on interest.
Because of that, APY is more accurate than a simple interest rate. The annual percentage yield is compounded more frequently and thus gives you the most accurate insight into a deposit’s earning potential.
In crypto, investors typically get APYs to keep coins in their accounts, stake tokens, or by providing liquidity to the liquidity pools.
How Is APY Calculated in Crypto?
No matter whether APY comes from traditional finances or crypto, its calculation follows the same logic and rules.
Calculating the API, the frequency of periods when the interest is applied, is critical. Interest can be compounded daily, monthly, or annually.
The method in which the interest is compounded has an effect on the APY. The greater the number of compounding periods per year, the higher amount of interest the users earn.
APY is calculated by dividing the annual interest rate in decimals by the number of compounding periods per year, adding 1 and raising it to the number of compounding periods, then subtracting 1. Here is the formula:
APY= (1 + R/N )^N – 1
R = the annual interest rate
N = the number of compounding periods per year
For example, the staking platform gives you 5% APY for staking tokens for one year. They also offer a monthly compound frequency (thus 12 compounding periods). You agree to stake $1,000 worth of tokens.
Following the APY formula would look like this: APY = (1+0.05/12)^12-1= 5.116%.
This means, at the end of the year, you will have $51.16 more in your account balance, or $1,051.16.
This might be a modest gain compared with the 5% simple annual interest rate, where interest is calculated once a year. But in the long term, using the APY or compound interest where gains are reinvested each month, the returns typically become much higher.
What Is the Difference Between APY and APR?
Whenever you are investing capital, different forms of interest do apply. One of them is an Annual Percentage Rate (APR), commonly confused with the APY.
In general, APR and APY are quite similar, except for the key difference when speaking about results.
APR is a simple interest rate that does not compound. Thus the investor earns the fixed profit on his or her initial investment.
Let’s take the aforementioned example of a $1,000 investment with a 5% yearly interest rate. At the end of the year, the investor will have $50 more in his account balance. After two years of investment, he’ll have $100 from interest. The investment amount will steadily grow, however, always at the same pace: 5% plus from the initial amount.
In the meantime, when choosing an APY, the investor gets interest on interest, added to the initial amount of investment. Because of the compounding, APY is capable of providing higher yield profits.
What Affects the Size of the APY?
Like any other market, the crypto space and APYs of the crypto products vary. APYs do change, sometimes even without any notice. Whether it increases or decreases depends on the market conditions.
Factors like general inflation, the macro-economic situation, the rate of supply and demand, and the frequency of compounding periods affect the final Annual Percentage Yield.
The only aspect you can influence yourself here is the frequency of compounding periods and the holding timeframe in total. The higher the amount of compounding periods does affect and expand the size of the APY.
Different Ways to Earn APYs in Crypto
The cryptocurrency space offers a wide variety of services for crypto hodlers or those who are looking for ways to increase their investment yields. Some of the ways to generate passive income are:
The process includes locking the Proof-of-Stake (PoS) protocol tokens into the staking pool, where they are used to support the blockchain network and confirm transactions. The participants are rewarded with interest for locking their coins.
Staking is one of the most popular ways to generate passive income. Mostly because some cryptocurrencies offer high APY rates for staking.
Liquidity providing and yield farming
Decentralized exchanges, or Automated Market Makers (AMMs) to be specific, introduced the new option for crypto holders to generate APYs on their digital assets. They offered them the opportunity to become liquidity providers for numerous cryptocurrencies.
Basically, it means that you deposit and lock up your crypto on a certain DeFi protocol and get the protocol’s native cryptocurrency as a reward. These cryptos are distributed proportionally by calculating the liquidity provider’s share of the total pool of liquidity.
Liquidity providers further may stake the tokens they get from the liquidity pools and thus earn additional yields (APYs) on their assets via yield farming.
Cryptocurrency lending is a rapidly growing segment of the lending investment space. It brings another opportunity for cryptocurrency holders to generate yields, this time by lending their digital assets to other users.
The online crypto lending platforms offer interest for cryptocurrency holders who want to earn regular passive income based on the amount of their assets.
Why You Should Care
Based on compounding, Annual Percentage Yield (APY) allows crypto holders to earn interest on interest, not on their initial investment alone. It is a popular investment tool, historically more profitable than a simple investment rate or Annual Percentage Rate (ARP).