Understanding DeFi interest rate conventions
A displayed interest rate in DeFi is never just a single number. It can represent a simple annual rate or a compounded return, a spot market condition or an average over time, and a base yield or a rate boosted by incentives. Two protocols showing the same headline percentage may therefore represent very different economic realities. Understanding the convention behind the number is essential before comparing lending markets.
APR, APY and compounding
APR represents the annualized interest rate before accounting for compounding. It is simply the periodic interest rate extrapolated over one year. APY incorporates the effect of compounding, where earned interest is added back to the principal and generates additional returns.
The relationship between APR and APY depends on the compounding frequency:
APY = (1 + APR/n)^n − 1
where n is the number of compounding periods per year. As the compounding frequency increases, APY approaches the continuous compounding case:
APY = e^(APR) − 1
DeFi protocols use different approaches to apply compounding. Aave V3 and Compound V3 use hourly compounding, while Morpho Blue applies continuous compounding.
The time window behind the rate
Every APY also depends on the time period over which it is measured. A spot rate represents the current market conditions at a specific block and can change immediately as supply and demand evolve. A large deposit, withdrawal, or borrowing event can significantly modify utilization and therefore the displayed rate.
To reduce this volatility, many interfaces and aggregators display averaged rates over a predefined window, such as 6 hours, 24 hours, or 30 days. These averages provide a smoother view of the market but represent a different measurement from a spot rate.
The time window is therefore a critical part of any rate comparison. A current APY from one protocol and a 30-day average APY from another are not directly comparable, even if they display the same label.
Rewards, incentives and fees
The displayed rate is not always the base lending yield generated by borrower demand. Many protocols add token incentives on top of the underlying interest rate, creating a higher headline APY.
These two components represent different sources of return. The base yield reflects actual borrowing activity within the market, while incentive rewards usually come from temporary distribution programs and depend on the value of the reward token itself.
Fees also affect the final return received by lenders. Protocol fees, performance fees, or vault management fees reduce the effective yield. For example, Morpho's protocol fee is deducted from borrower interest before the resulting Supply APY is calculated.
Understanding the breakdown between base yield, incentives, and fees is therefore essential when comparing advertised rates across protocols.
What this means when comparing rates
A single percentage can hide several underlying assumptions: the compounding method, the measurement window, and the composition of the displayed yield.
Two markets showing the same APY may differ significantly in how that return is generated, how stable it is, and what risks are embedded in it. A proper comparison requires looking beyond the headline number and separating the base rate, compounding convention, time window, incentives, and fees.
Only once these components are aligned does comparing two lending rates become a meaningful comparison.