Borrowing and lending are common parts of trading commodities. Many traders borrow and lend various commodities daily. This practice has been in use since the dawn of time. Recently, the process has been institutionalized. Nowadays banks loan money to borrowers on interest.
This interest can be of two kinds. It can be simple interest or it can be compound interest. Simple interest is often applied once a year and compound interest is applied often more than once a year. Both of these types are of common use these days. This practice is followed all over the world by international banks as well as local banks.
Interest is one of the ways banks make money. They provide a lump-sum amount to the customer as a loan and then take back the loan in form of installments. Usually, these installments are paid on a monthly basis. The bank then charges a percentage on the principal amount, which is called interest.
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This interest rate determines the total amount paid to the bank at the end of the loan tenure. The percentage of interest rate is decided by the bank and the customer has to agree with it at all costs. The bank usually takes a guarantee from the customer as a precautionary measure in case the customer fails to deposit the money.
Money can also be borrowed from individuals instead of banks. Certain individuals also provide loans to others. They also charge interest rates and they also offer simple interest as well as compound interest. This type of borrowing is usually common in cryptocurrencies.
Since there are no banks that use cryptocurrencies, therefore, lending and borrowing of cryptocurrencies are usually managed by individuals, rather than banks. There are two basic terms that you need to be completely familiar with, to understand the phenomena of borrowing and lending in cryptocurrencies. These terms are APR and APY.
These are two different terms and have two completely different meanings. These terms are often used in the crypto world and one must understand these terms thoroughly to be able to understand the crypto world completely.
APR and APY describe the total amount the borrower owes to the lender. This is the total amount that the lender expects to get back from the borrower from a specific agreed time. These terms help the borrower to understand the extent of liabilities at his end so that he can make an informed decision at the end.
What is APR in general?
Consumer Financial Protection Bureau (CFPB) defines the annual percentage rate or APR as it is the total amount paid to borrow the required sum of money. This is a kind of interest rate. This kind of interest rate is generated yearly and it is also known as a credit card interest rate.
This interest is usually generated yearly and the total amount paid to the lender is often added to it. The interest rate is charged at the end of each year and the principal borrowed amount is added to it. Usually, this rate is added as a fixed percentage to the principal amount. The borrower has to pay the sum of the borrowed amount and the principal amount.
For example, if a person borrows $200 and the APR is 5%, then his principal amount is $200 and the interest rate or APR is 5%. The total amount paid at the end of the year will be the sum of the principal amount and APR. 5% of $200 is $10. So the total amount paid at the end of the year will be $210.
Understanding APR is important while taking a loan because it enables the borrower to understand the total amount he owes to the lender. Also, it helps determine the total amount that is to be paid to the lender. This helps the borrower to calculate the total risk and liabilities at his end and make an informed decision accordingly.
In the case of credit cards, APR is not charged when the card is used. At the end of each month, the credit card company issues a bill to the customer. If the customer pays that bill within the due time, then the bank charges no interest.
On the other hand, if the customer fails to pay the bill on time, in that case, the bank imposes a penalty on the customer in the form of interest. This interest is APR and it is charged when the customer fails to deposit the due money on time. This interest is charged on the outstanding amount every month.
What is APR in crypto?
Now that the concept of APR is clear in general, we will now look at the concept of APR in the crypto world. The concept of APR in the context of cryptocurrencies is quite different. In a general sense, the APR is usually charged by a firm or a bank. It may be charged at the end of a month or the end of a year. However, the case of APR in crypto is different altogether.
In the case of cryptocurrencies, there are no banks that operate on cryptocurrencies. They don’t have reserves of cryptocurrencies, therefore, they don’t offer cryptocurrencies as loans. In this case, the customers have to rely on other sources to get the loan. This loan is provided by other individuals who have a considerable portfolio of that particular cryptocurrency.
In cryptocurrency, APR is considered to be a percentage that the investor or the lender charges as a fee for lending his cryptocurrency or making it available for others to use. This is a slight difference from the general sense of APR because, in cryptocurrency, the APR is usually considered as a fee rather than an interest.
APR is considered a fee that the borrower has to pay the lender to get the required cryptocurrency. This is usually based on the concept of simple interest, which means that there is only a simple amount paid at the end of the tenure and there is no compound interest involved.
The process of charging APR in crypto is the same as in general. A percentage is charged on the principal amount and then the sum of the principal amount and the APR is paid to the lender. The percentage is usually charged on a yearly basis. But it can be changed to accommodate shorter periods as well.
If the borrower wishes to borrow the cryptocurrency for a shorter period, then this is accommodated by adjusting the APR rate. For example, if the APR rate of a particular lender is 6% and the borrower wishes to take the loan for six months, then the APR will be 3% for six months. Therefore, at the end of six months, the borrower has to pay the principal amount plus 3% to the lender.
APR is straightforward to understand. If a person wishes to invest 1 ETH in a crypto lending pool on a Defi network for one year, then the total amount at the end of the year will be the sum of the principal amount and the APR. Usually, the APR for ETH is about 24%, this means that the investor will get 0.24 ETH at the end of the first year as APR and the total amount at his disposal will be 1.24 ETH after one year.
How to calculate APR
APR can be calculated by using a simple formula.
A = [ P * ( 1 + RT ) ]
T is the time of loan or investment in years
R is the interest rate used
P is the Principal amount
A is the final amount paid to the lender.
For example, if 1.0 ETH is invested for one year at 24% APR then the total amount paid to the investor will be:
P = 1.0 ETH
R = 24% or 0.24
T = 1
A = ?
A = [ P * ( 1 + RT ) ]
A = 1.0 ( 1 + 0.24*1 )
A = 1.24 ETH
So at the end of one year, the total amount paid to the investor will be 1.24 ETH.
Similarly, if the amount is invested for six months, rather than one year, then the total amount paid to the investor will be:
P = 1.0 ETH
R = 24% or 0.24
T = six months or 0.5
A = ?
A = [ P * ( 1 + RT ) ]
A = 1.0 ( 1 + 0.24*0.5 )
A = 1.12 ETH
Another formula to calculate APR is:
APR = [ ( Fees + Interest) ÷ Principal ] ÷ n * 365 * 100
This formula can also be used to find APR.
What is APY in crypto?
The concept of APY is quite different from APR in crypto. APY stands for Annual Percentage Yield. APY is a way that measures how much money an investor can make on an interest-bearing account. APY calculates the interest not only on the principal amount but on the interest amount as well.
APY measures the rate of return on the investment. It is much more sophisticated than APR to calculate. APY calculates the profit not only on the principal amount but on the interest amount as well.
APY is also called compound interest. Compound interest is the second type of interest as mentioned earlier. It is different than simple interest in a way that the simple interest or APR only calculates the interest on the principal amount, adds the interest rate, and then calculates the total amount paid.
On the other hand, APY or compound interest calculates the interest not only on the principal amount but also on the interest as well. Then adds all the values at the end and presents the final value that the borrower owes the lender. The interests taken on APY are much more in value than the APR. That is the reason why APY is much more profitable than APR.
In the crypto community, the investors can invest their portfolios in a pool based on APY rules. The investors can also use their coins for staking purposes in different pools that offer payments on APY. This way investors can make a lot of money from their basic portfolio. This helps the investors to make as much money as they can while ensuring that their assets are safe and secure.
APY is also offered by some saving accounts as well. Investors can even stake their coins in a savings account and enjoy the perks of APY payments. There is one catch though, the percentage offered by the savings account is often less than the percentage offered by staking pools or other investors.
Investors can use Defi protocols, crypto exchanges, and online crypto wallets to start earning APY on their holdings. Various platforms offer these services to investors. Usually, the APY is paid in the same currency that is staked with the investor.
However, in some cases, the APY could also be paid in different currencies as well. Bitcoin, ETH, and LUNA are among the top currencies that investors invest in based on APY payments.
How is APY calcualted?
The calculation of APY is also different from APR. APY can be calculated daily, weekly, bi-weekly, monthly, or annually. The calculation of APY is a little bit more complex than APR. This is because the interest is also calculated on the already imposed interest, therefore the calculation becomes a little bit more difficult.
The formula for calculating APY is:
APY = ( 1 + r/n ) n – 1
r is the period rate
n is the number of the compounding period.
For example, if 1000 coins are compounded for 10% interest daily, then after the first year the total amount including the interest will be 1105. Similarly, at the end of the second year, this amount will increase to about 1221. This way the amount that is compounded always increases with each passing cycle. Therefore, the more time an amount is compounded, the more profit it makes.
The normal rate for APY in crypto is about 1%. However, some platforms offer almost 7% APY on selected cryptocurrencies. Similarly, one can earn up to 10% APY on some savings accounts. Moreover, some Defi platforms like SushiSwap (SUSHI) offer up to 100% APY to investors.
APY vs APR: Main Differences
Both the APR and the APY are types of interest. They both offer a way of passive income for investors. Investors can suitably invest their coins and earn handsome profits from them.
APR is the sum of interest on a principal amount. The total amount paid to the lender at the end of each year becomes the sum of the principal amount and the interest rate. This type of interest rate is more suitable for borrowers.
APY on the other hand is the hand calculates the interest on the principal amount and the already imposed interest as well. This way the amount of APY increases with each iteration. On the other hand, the APR remains the same with each iteration. This is the reason why the APY is preferred over APR by investors because APY offers a greater return on investment than the APR.
APY vs APR: Which is better?
Both the APR and the APY have their pros and cons depending upon the situation. Both offer some advantages for one set of people and some disadvantages for another set of people. For instance, investors generally prefer APY, because it offers a greater return on investment. On the other hand, APR is usually preferred by borrowers because they have to pay relatively less amount at the end of their tenure.
APY provides a clear image of the earning potential of an account. Investors can use the APY formula to calculate the potential of the number of coins they hold.
They can use the formula to calculate and compare the different rates offered by different sources and then based on the data, they can decide on the platform that they want to invest in. This way, APY provides crucial information to investors about the investment opportunities for their portfolio.
Moreover, the APY can be compounded more than once a year. It can be compounded monthly, weekly, or even daily. This means that the interest can be earned daily, unlike the APR where the investor has to wait for a whole year to earn profit. The APY has the potential to offer daily rewards and that is why APY is preferred by investors worldwide.
On the other hand, APR is generally opted for by borrowers. This is because in APR the principal amount is compounded annually. So, the borrowers have to pay less amount in interest. All they have to pay is the principal amount and a little extra amount over it as part of interest.
Therefore, the understanding of APY and APR is of paramount importance while investing and borrowing crypto because one has to pay the interest rate according to the plan one opts for. The borrowers and investors need to keep an eye out for the type of plan they choose because it has a huge impact on their crypto portfolio.
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