APY vs. interest rate explained: What investors need to know

If you're earning yield on your assets, you've probably come across two common terms: APY and interest rate. Whether you are slowly building your savings account with a traditional bank, or earnings rewards from the latest decentralized finance protocol, these terms appear everywhere in finance. 

At first glance, they might seem interchangeable, but understanding the difference can help you make more informed decisions about where and how you allocate your assets. This is especially true in crypto investments, where rates can fluctuate and platforms vary widely in how they calculate returns. 

In this post, we’ll break down what APY means, how it compares to a standard interest rate and how these figures can impact your earnings. We’ll also cover what to watch for when evaluating crypto yield opportunities so you can make decisions more confidently.

The annual percentage yield (APY) and interest rate are both percentages used for estimating yearly returns. However, their fundamental difference is that APY takes compounding into account, while interest rate does not. In other words, APY takes into account earnings being reinvested back into the initial deposit, whereas the interest rate does not. 

You're more likely to find APY associated with activities like staking or liquidity pools that automatically reinvest earnings. By contrast, interest rates are more shown by lending protocols and fixed-yield accounts.

Taking compounding into account helps crypto investors compare earnings rates on an "apples to apples" basis rather than solely relying on the posted percentages. 

Interest rates are flat percentages on a user's principal that are either earned or paid annually. 

In crypto, interest rates represent how much you'll earn or owe for depositing or borrowing digital assets before compounding. 

As an example, suppose you loan out 1 Ether (ETH) at a 5% annual interest rate on a decentralized finance (DeFi) protocol. In this case, you'll earn 0.05 ETH in a year.

True to their name, simple interest rates are simple to calculate. If a crypto protocol offers an interest rate percentage, you only need three variables to figure out expected earnings: 

• Principal: The initial deposit you put on the platform, or the amount you're taking out for a crypto loan. 
• Rate: The posted interest percentage advertised on the protocol. 
• Time: Typically one year, but double-check how the platform calculates this rate. 

After multiplying all of these factors, you'll see your crypto's expected earnings or payments.

Say a crypto lending platform offers a 2% annual interest rate on Bitcoin. To figure out how much you'll get in your crypto wallet in one year with a 0.5 Bitcoin (BTC) deposit, use this simple interest formula:

• 0.5 BTC x 2% x 1 year = 0.01 BTC

While the core feature here is a lack of compounding, there are a few nuanced interest rate models to consider. Each interest rate formula calculates expected payments or returns slightly differently. 

• Compound interest rate: Similar to APY, the compound interest rate factors the principal and accumulated interest into its calculation. However, only the effective APY reveals your total annual earnings — the compound interest rate is the advertised percentage you use to figure out the effective APY. 
• Fixed interest rate: The fixed interest rate adds time to the equation with a finite limit to an investment term with a constant interest rate. For example, a fixed 6% rate on a 30-day lending offer lasts 30 days.
• Variable interest rate: By contrast with fixed interest rates, the percentage in variable interest rates changes in response to market fluctuations or protocol dynamics. A DeFi lending rate might automatically adjust crypto yields based on the platform's latest supply and demand. 
• Nominal interest rate: Similar to the simple interest rate, nominal interest rates don't include compounding or inflation in their calculation. Usually, nominal interest rates are labels used in advertising, while the simple interest rate refers to the calculation method. For example, a crypto platform advertises a 6% nominal interest rate on Tether (USDT) savings. If it pays out interest monthly but doesn't reinvest it, your earnings are based on a simple interest rate — 0.5% per month on your original deposit.
• Real yield: A real yield percentage considers token price changes when quoting returns. This is a big deal for crypto rewards paid in volatile tokens. For example, say a crypto staking pool offers a 20% interest rate for staking an altcoin. The real yield is negative if this token loses 25% of its value over the year.  

You might see APY labeled as the "real rate of return" because it adds reinvested rewards to its yearly estimate. 

Accounting for compounding gives you a more reliable read on returns for many popular crypto-related activities. Services like staking pools and liquidity protocols usually auto-reinvest earnings, so investors need an APY calculation for accurate final estimates.

Because compounding adds complexity, the APY formula is more involved than that for interest rates:  

• APY = [1 + (r ÷ n)]ⁿ - 1

In this calculation, the "r" value represents the nominal interest rate, while "n" represents the number of compounding periods per year.

Let's review a simple example to see how this plays out in DeFi. Say you stake Ether with a nominal interest rate of 5% compounded monthly (n = 12). In this scenario, you'd plug in the numbers as follows: 

• [1 + (0.05 ÷ 12)]¹² - 1 ≈ 0.0512 or 5.12% APY

So, your effective annual yield on ETH would be 5.12% due to monthly compounding. Just keep in mind this assumes a constant for ETH's price and the quoted APY, so what you gain at the end of an annual term isn't set in stone. 

You could also use APY with currencies like the USD to get a sense of the fiat value of APY on crypto assets. For instance, if someone wanted to know what 5% APY is on $1,000 compounded monthly, they'd use the same 5.12% rate found above to determine their yearly gain (or $51.20).

Similar to interest rates, there isn't just one APY formula to consider. While variable APY is popular in DeFi, there are plenty of other models to review when comparing rewards: 

• Nominal APY vs. effective APY: Nominal APY is the stated interest rate without accounting for compounding frequency, while effective APY reflects how often interest compounds (e.g., daily, weekly or monthly). So, the nominal APY is what you see advertised, but the effective APY is what you actually earn on your crypto. 
• Projected APY: Often found on DeFi platforms, projected APY is the current best estimate based on current market conditions. Think of it as forecasting what you can expect to earn with today's rates. 
• Variable APY: The most common percentage in DeFi, variable APY automatically adjusts according to a protocol's built-in programming. Due to supply and demand, token price changes and updated rules, users may see fluctuations in their earnings over time.
• Fixed APY: While uncommon in DeFi, fixed APYs are often found in centralized finance (CeFi) platforms or staking programs that lock your funds. Unlike variable APY, these rates stay set for a specific term for greater predictability.

Although annual percentage rate (APR) looks similar to APY, it reveals completely different information about your earnings. APR represents the annualized interest rate without accounting for compounding. It simply reflects how much interest you’ll earn on your crypto over a year. 

APR expands on the interest rate by including platform or protocol fees and token distribution costs. While this gives a better picture of earnings or loan obligations, it doesn't include compounding. 

On the other hand, APY takes compound interest into account when reflecting annual interest. It provides a more accurate picture of earnings and is useful when seeing the full scope of your yields. If protocols automatically reinvest crypto rewards — or people add distributions to their principal — they need to know the APY.

Whether the APY or interest rate matters more depends on whether compounding fits into your strategy.  

APY matters more for activities like staking, yield farming and liquidity pools where automatic reinvestments are common.

Interest rates are more common with crypto loans because they only show the base rate but might also feature in specific fixed-term earnings programs. 

So, as a rule of thumb, APY is more important with any opportunities that involve reinvesting crypto rewards. By contrast, the interest rate is more useful for getting an accurate read on short-term positions, fixed-rate offerings or loan repayments.

In the United States, all crypto earnings are considered taxable income. That means you’ll owe income tax on any interest or rewards earned from holding or lending crypto. 

In addition to income tax, if you later sell or dispose of crypto and its value has increased since you acquired it, you may owe capital gains tax on the difference. How a platform pays out crypto earnings can also influence this tax treatment. 

For example, some platforms distribute crypto earnings as rewards or bonuses rather than direct interest. In these cases, tax authorities may treat the distribution as a capital asset event, meaning you could owe capital gains tax either when you receive or sell tokens.

When you're comparing activities like yield farming or crypto loans, pay careful attention to the APY vs. interest rate for the most accurate comparisons. 

If you're just getting started with activities like staking or DeFi, remember to check out the Kraken Learn Center for more easy-to-read insights into how web3 works. 

Ready to dive into your next crypto investment? Get started with Kraken today and enjoy easy access to hundreds of digital assets, plus a secure crypto staking portal.