The rise of cryptocurrencies has led to a wave of new financial products, many of which offer extremely attractive yields to investors.
One important metric used to evaluate these products is APY or annual percentage yield.
In this article, we will explore what APY is, how it relates to crypto, and some additional factors to consider when evaluating yield products in the crypto space.
What is Annual Percentage Yield?
APY, or annual percentage yield, is a way of expressing the total amount of interest or returns you can expect to earn on an investment over the course of a year, expressed as a percentage of the initial investment.
APY takes into account the effects of compounding interest, which means that interest earned on an investment is reinvested, resulting in a larger balance and, thus, even more interest over time.
Explanation
To understand how APY works, let’s consider a hypothetical example.
Suppose you invest $10,000 in a financial product that offers a 10% APY. After one year, you would have earned $1,000 in interest, bringing your balance to $11,000.
If you leave the money in the product for another year, your APY would be calculated based on the new balance of $11,000, resulting in even more interest earned in the second year.
This is the power of compound interest and becomes increasingly important the longer it occurs as you earn interest on an ever-growing initial deposit.
APY vs APR – Compound Interest
It’s important to note that APY is different from APR, or annual percentage rate.
APR is simply the interest rate that you pay or earn on an investment or loan over the course of a year. A common example of this would be a credit card interest rate.
However, APR doesn’t take into account compound interest (previously earned interest), which means that the actual returns you earn may be lower than the APR.
In contrast, APY will take into account compounding interest, so it gives a more accurate representation of the total returns you can expect on an investment.
What Does APY Mean in Crypto?
Crypto Lending
In the world of cryptocurrencies, there are many platforms that allow investors to lend their crypto assets to other users in exchange for interest.
These lending platforms frequently advertise these investments as crypto savings accounts and use APY to calculate the interest rate that lenders can earn on their investments.
For example, suppose you lend $10,000 worth of Bitcoin on a platform that offers a 5% APY. After one year, you would have earned $500 in interest.
Crypto Borrowing
On the other side of this lending equation, there are platforms that allow users to borrow cryptocurrencies in exchange for collateral.
The interest rate that borrowers must pay is also calculated using APY. For example, imagine you borrow $10,000 worth of Ethereum on a platform that charges a 10% APY.
After one year, you would have to pay back $11,000 to the lender, which includes the initial loan amount (principal) plus $1,000 in interest.
Yield Farming
Yield farming is a relatively new concept in the crypto world that allows investors to earn rewards in the form of new tokens by providing liquidity to decentralized finance (DeFi) protocols.
These rewards are calculated using APY and can be quite high, sometimes reaching 100% or more.
However, yield farming can also be quite risky, as it often involves interacting with unaudited smart contracts and new, untested protocols.
Crypto Staking
Crypto staking is a way of earning rewards by holding certain cryptocurrencies and participating in the validation of transactions on a blockchain network.
Staking rewards are typically calculated using APY and can be quite attractive, sometimes exceeding 10% or more.
That said, staking also carries some risks, as the value of the staked cryptocurrencies can fluctuate, potentially resulting in losses.
APY in Crypto: Additional Considerations
When it comes to APY in the crypto world, there are some additional considerations to keep in mind.
Here are a few key factors to consider when evaluating crypto yield products.
Liquidity
One crucial factor to consider is the liquidity of your crypto assets.
When you lend your crypto or stake it in a yield farming platform, it’s typically locked up for a certain period of time.
This means you won’t be able to access it during that time, which could be problematic if you need to sell your crypto quickly to take advantage of a price spike.
Ensure you understand how long your crypto will be locked up (illiquid) before committing to any yield product.
Crypto Fluctuations
Another factor to consider is the volatility of the crypto market.
While a high APY might look attractive, it’s important to remember that the value of your crypto assets can fluctuate rapidly.
If the price of your crypto drops significantly while it’s locked up in a yield product, the APY might not be worth it in the end, as the losses from the coin/token might far exceed any interest gained.
Consider the risks associated with the crypto asset you’re considering investing in, and ensure that the APY is worth holding that asset for the specified period.
Risks
Crypto yield products, like any investment, come with notable risks of which all investors should be acutely aware.
While “interest” investments are generally preferred due to their low risk, the volatile nature of cryptocurrencies can make them a riskier investment option.
It’s important to research the company offering the yield product and ensure they are trustworthy and reliable before agreeing to lend them any assets, regardless of the yields they might offer.
Make sure to do your due diligence and assess all the risks before investing your hard-earned crypto.
Crypto Investments Are Not Insured
It’s important to note that crypto yield products are not insured by the FDIC, SIPC, or any other regulatory agency like many investments in traditional finance.
This means that if the company offering the yield product were to go bankrupt or experience a hack, there is no guarantee that you would be able to recover your crypto assets or interest paid.
Make sure you understand the possibility of losing your investment and are comfortable with the level of risk associated with a particular yield product before investing.
Comparing Rates
Finally, it’s important to compare interest rates among different companies offering yield products.
While a high crypto APY might seem attractive, it might not always be the best or safest option for investors.
As a general rule of thumb, the higher the APY, the higher the risk, so choosing the most lucrative investment isn’t always the best choice.
Do your research and compare rates across multiple platforms before making any investment decisions.
It can also be helpful to consider the reputation and history of the platform in question. All else being equal, lending money to a reputable company is a safer bet than a relatively unknown one.
Conclusion: APY in Crypto
APY can be a valuable tool for investors looking to measure and maximize their returns on crypto assets.
However, it’s important to understand what APY is and how it differs from APR by calculating compound interest, as well as the specific considerations that come with investing in crypto yield products.
By doing your due diligence and assessing the risks associated with any particular yield product, you can make informed investment decisions and take advantage of the potential benefits of APY in the world of cryptocurrency.
