What is the APR?

APR stands for Annual Percentage Rate. It is a key financial metric used to express the annual cost of a loan or the annual return on an investment, without taking into account the effect of compound interest.

What do you need to know?

• How does APR work?
• Risks of APR
• How is APR calculated?

How does APR work? 

APR (Annual Percentage Rate) applies to an investment, loan, or line of credit. Unlike APY (Annual Percentage Yield), APR does not take into account the effect of compound interest and is calculated simply by multiplying the periodic interest rate by the number of periods in a year.

In the realm of cryptoassets, APR primarily focuses on the simple annual interest rate without considering compound interest.

Risks of APR

It should be clarified that APR, per se, has no risks as such, given that it is only a mathematical formula. There may be some risks related to the use made of this APR, focused mainly on the market in general. Some of these coincide with those of APY, to which the following could be added:

• Reinvestment Risk: since APR does not consider compound interest, there may be a risk associated with reusing the rewards generated. If interest rates change, the profitability could be different from the initial APR interest rate.
• Inaccurate Comparison: when comparing different investment or loan opportunities, using APR instead of APY can lead to inaccurate comparisons, as the effect of compound interest on the total return is not taken into account. This can make some investments or loans seem more attractive than they really are. That is why it is important to carefully study whether the offer is with APY or APR.
• Inflation Risk: while this risk may also be present in the case of APY, APR does not consider the effect of inflation on the real return of the investment. If the inflation rate is high, the real return obtained through APR could be lower than expected.
• Market Volatility: cryptoassets can experience significant fluctuations in their value, which could affect the actual return obtained through APR.
  
  

How is APR calculated?

APR is calculated by multiplying the periodic interest rate by the number of periods in the year in which it was applied. It does not indicate how many times the rate is actually applied to the balance.

APR = ((((Fees+Interest) / Principal) / n) × 365 ) × 100

where:

Interest = Total interest paid over the life of the loan

Principal = Loan amount

n = Number of days in the loan term

Financial instruments may have different ways of calculating this type of interest rate. For example, on a credit card, these values vary depending on the type of charge, the person's credit history, and in some cases by the level or type of credit card. In addition to this, other factors such as cash advances, late payments, or other functions of said cards, which can affect the APR, may also be taken into account.

For their part, bank loans usually have a fixed or variable APR. A loan with a fixed APR has an interest rate that is guaranteed not to change over the life of the loan or credit. A loan with a variable APR, on the other hand, has an interest rate that can change at any time, depending on market conditions, regulations, or any element that the banking entity deems relevant to take into account.

In any case, APR does not take into account the compounding of interest within a given year: it is based solely on the simple interest applied to the funds.

If we want to use an example focused solely on the crypto sphere, it must be taken into account that the cryptoasset may not maintain a 1:1 parity with the euro, and therefore possible fluctuations in the price of the cryptoasset must be considered. Despite earning a 10% APR in the denomination of the cryptoasset, the profitability translated into euros could be lower or higher depending on the value of the cryptoasset against the euro.

For example, in this scenario, a deposit is to be made using cryptoassets on a DeFi platform. The platform offers a 10% APR on deposits of a certain cryptoasset.

The assumption is based on making a deposit in a cryptoasset worth 1,000 units, and the interest is based on a 10% APR rate.

Deposit Amount: 1,000 cryptoasset units

APR: 10%

Annual Interest: (1,000 units) * (10%) = 100 cryptoasset units

If the deposit term is 1 year, the total amount of interest at the end of the year will be 100 units. Therefore, the Deposit Amount + Interest = 1,000 units + 100 units = 1,100 cryptoasset units.