APY vs interest rate explained: what investors need to know

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 accounts for compounding by reinvesting earnings back into the principal, while an interest rate reflects only the base return.

In crypto, 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 commonly associated with 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 percentage.

The table below outlines the differences between APY and interest rate, how they typically apply to crypto-related activities and various use cases.

Let’s say you invest $10,000 in a crypto staking pool with a 12% interest rate, compounded monthly. The table below demonstrates the difference between APY and interest rate for that scenario.

The $68 difference may seem small on $10,000, but at $100,000 that gap becomes $680, and grows significantly the longer funds remain staked.

APY is commonly used across these crypto activities:

• Staking — Locking up ETH or SOL to earn compounded rewards

• Yield farming — Providing liquidity to DeFi protocols like Uniswap or Aave

• Crypto savings accounts — Platforms like Nexo or Coinbase offering interest on held assets

• Lending protocols — Supplying crypto to borrowers via platforms like Compound

• Liquidity pools — Depositing token pairs to earn compounded trading fees

APY is often the preferred metric in crypto because most protocols automatically reinvest rewards, making compounding the norm rather than the exception.

Interest rates are flat percentages applied to a user's principal, representing what is earned or owed annually. In crypto, interest rates represent how much you'll earn or owe for depositing or borrowing digital assets, excluding the effects of 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 that 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.

The table below compares annual percentage rate against annual percentage yield to help you understand the difference and determine which is right for you.

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.

While APY and interest rates describe how returns are calculated and displayed, they don’t directly determine your tax obligations. However, since APY includes compounding and can result in more frequent payouts, it might lead to more frequent taxable events.

In all cases, it’s essential to track your crypto earnings and transactions carefully and consider consulting a tax professional familiar with cryptocurrency rules in your jurisdiction to ensure you comply with reporting requirements.

Read our guide to learn more about U.S. crypto tax and the latest IRS updates.

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.