APR in cryptocurrency: how the annual percentage rate works

When choosing assets to invest in, investors and traders look at various indicators, one of the most informative being the Annual Percentage Rate (APR).

However, when using APR in cryptocurrency, it is important to understand certain nuances. Otherwise, the picture of what is happening in the cryptocurrency market may be significantly distorted, and the investor may end up with results that differ from what they expected.

What is APR (Annual Percentage Rate)?

Annual Percentage Rate, or APR, in cryptocurrency is a financial metric that reflects the annual return on a particular investment or trading asset without taking interest compounding into account.

Originally, the term Annual Percentage Rate was used for traditional financial instruments, including bank deposits and treasury bonds.

However, with the development of the DeFi market, investors and traders have increasingly used APR to calculate returns on investments in various instruments, such as:

• Loans;
• Yield-bearing stablecoins;
• Liquidity mining and farming pools;
• Indexes;
• Savings accounts and deposits;
• Staking and mining.

Important: in cryptocurrency services, APR most often represents an estimated rather than guaranteed return. The displayed value may be based on the protocol's current performance metrics and may change along with market conditions. For example, Lido explicitly states that the displayed APR is a current estimate of rewards rather than a forecast of future returns.

Differences between APR and APY in cryptocurrency

Inexperienced users can easily confuse APR (Annual Percentage Rate) with a similar metric known as APY (Annual Percentage Yield). The difference is that APY takes interest compounding into account, whereas APR does not. In this context, interest compounding is a mechanism in which accrued income is added to the principal investment amount and participates in subsequent accruals. As a result, returns may be generated not only on the initially invested funds but also on previously earned interest.

Compounding can increase investment returns through compound interest. This may occur, for example, when reinvesting income, i.e., investing the income received again in the same or another financial instrument.

APY makes it possible to calculate investment returns more accurately because it takes into account both the interest rate and the frequency with which payments are made. Achieving the same level of accuracy can be more difficult when calculating the Annual Percentage Rate, or APR, in cryptocurrency.

How to calculate APR?

One of the main advantages that makes APR so popular among investors and traders is the simplicity of calculating the Annual Percentage Rate.

To calculate the Annual Percentage Rate, it is enough to use a simple formula:

APR = (annual income / initial investment amount) × 100%

The Annual Percentage Rate (APR) shows the annualized return on an investment without taking interest compounding into account. It is calculated as the ratio of the income accrued over one year to the principal investment amount, multiplied by 100%. The resulting value shows what percentage of the initial investment amount a user may earn over one year if the stated rate remains unchanged.

For example, if an investor deposits 5,000 USDT into a liquidity pool and the APR in cryptocurrency is 15% per year, after one year the return on the investment will amount to 750 USDT.

If the funds are deposited for less than one year and the rate remains unchanged, the approximate return can be calculated proportionally to the duration of the investment. For example, at a 15% APR, depositing 5,000 USDT for six months would generate approximately 375 USDT in income, excluding compounding and additional expenses.

However, this calculation only works if the APR remains unchanged. If the rate changes during the period, the actual return should be calculated based on the rates and duration of each period rather than simply using the latest displayed APR.

Strengths and weaknesses of APR

The Annual Percentage Rate (APR) is a simple and easy-to-understand metric that even inexperienced cryptocurrency users can calculate without much difficulty.

Another advantage of APR is that it makes it convenient to compare different financial instruments. If several protocols specify their returns in APR, users can convert them into a common annualized metric and make a preliminary comparison of their potential returns. However, APR alone is not sufficient when choosing an instrument: identical rates may be associated with completely different levels of risk.

However, the Annual Percentage Rate, or APR in crypto, has limited applicability — it can only be used to calculate the returns of investments made at the same frequency, for example, when using a DCA* strategy.

* DCA (Dollar-Cost Averaging) is an investment strategy in which an asset is purchased for the same amount of money at regular intervals regardless of its current market price. This approach helps average the asset's purchase price and reduce the impact of short-term market fluctuations.

It should also be kept in mind that the Annual Percentage Rate (APR) is a dynamic metric that depends on the amount of assets in liquidity pools and demand (for example, trading volume on decentralized exchanges and the amount of cryptocurrency borrowed through lending protocols). As a result, final calculations may be significantly distorted and differ considerably from the returns expected by the investor.

For example, newly launched decentralized protocols may offer APR rates reaching or even exceeding 1,000% per year. However, over time, as the amount of assets in liquidity pools increases, the rate may fall to 10–30% or even lower.

Staking APR, among other things, may be determined through open community voting, making it extremely difficult to predict.

What to consider besides APR

Before investing funds, it is worth evaluating not only the stated APR, but also several additional factors: the source of the yield, the historical stability of the rate, the currency in which rewards are paid, fees, withdrawal conditions, and the risks associated with the protocol itself.

For example, a hypothetical 8% APR generated from sustainable fees paid by protocol users and a 50% APR, most of which is paid in a newly issued token, represent economically different types of returns and involve different levels of risk.

Therefore, APR is primarily useful as a metric for initially comparing different offers, but it should not be treated as a standalone measure of their profitability or reliability.