Compound interest is the act of earning interest on your interest. This means that if you invest an amount of cash in a savings account (called your principal), the interest you earn is directly added to your principal amount. When you earn interest in the future, you are earning interest on your principal plus on the interest you have already earned over time.
For example, if you had $100 in a savings account that earned 5% annually, you would have $105 at the end of the first year. During the second year, you would earn 5% interest on that $105, meaning that you would have $110.25 at the end of year 2.
Compound interest is an attractive feature to potential investors because the rewards one earns on their principal investment is added to each subsequent payment period. If we use the previous example again over 10 years, the $100 principal investment would turn to $162.89 with compound interest, and $150 without it.
In the cryptocurrency and blockchain world, investors often earn rewards when they stake their assets on a network. In that instance, that blockchain is “borrowing” these crypto assets for a specific purpose, such as for liquidity, validation, security, and efficiency, among other things. In exchange for borrowing your crypto, the network provides you with rewards. You can read more about staking in Bitstamp’s “What is staking?” article.
Further, in crypto, much like in a typical savings account, you can earn both compound and simple interest by also lending your assets through traditional finance institutions.
How to calculate compound interest
The compound interest formula is:
A is the final amount, P is the principal amount, r is the interest rate, n is the number of times interest is applied per time period, and t is the time elapsed.
See below for an example.
APR vs APY
Annual percentage rate (APR) and annual percentage yield (APY) both indicate the rate of return one can expect in a year on an asset. The key distinction between the two is that only APY factors compounding interest into the rate of return.
While APR and APY should be something you must be conscious of when you are borrowing money, for the purposes of this article they will be in reference to what you can earn on crypto assets on a yearly basis.
When earning rewards via staking, these rewards are often paid out in that native cryptocurrency and periodically at different time intervals (such as monthly, quarterly, or even daily, depending on the network’s rules), and the rate that someone earns from staking is expressed as yearly rate of return, either in APY or in APR.
What is annual percentage yield? (APY)
The annual percentage yield factors the compounding interest into the final total. APY is generally more attractive to an individual because their principle will grow faster vs APR.
At Bitstamp, you can earn APY by staking your ETH (4.19% APY, paid out monthly) and ALGO (5% APY, paid out quarterly). Please note that these rates were taken in October 2022 and are subject to change.
For example, if you wish to stake 100 ALGO for two years, at the end of year 2 you will have:
Using the same formula, if you wish to stake 100 ETH, you will have 108.73 ETH at the end of year 2.
What is annual percentage rate? (APR)
The annual percentage rate is the amount of rewards you will earn on your principle yearly and does not include compound interest.
The APR interest formula is:
A is the final amount, P is the principal amount, r is the interest rate, and t is the number of years your investment is earning rewards.
For example, if we used 5% APR instead of APY in the ALGO example above, the total amount of holding 100 ALGO after two years would be:
Of note: the terms APR and interest rate are not synonymous as APR can include other fees or costs.
Bitstamp Earn
With Bitstamp Earn participants can obtain staking rewards on their cryptocurrency. In 3 simple steps, you can begin earning rewards on your assets.
Step 1: Create an account and choose existing crypto or buy new assets.
Step 2: Select the amount of crypto you wish to stake or lend. Some cryptocurrencies grant you rewards by default, others require a minimum amount to stake or lend.
Step 3: Start earning rewards