The difference between simple and compound interest can mean tens of thousands of dollars over your lifetime. Understanding this distinction is crucial for making smart decisions about savings, investments, and loans.
What Is Simple Interest?
Simple interest is calculated only on the principal amount—the original sum of money. No matter how long you save or borrow, interest is always calculated on that initial amount.
Interest = Principal × Rate × Time
I = P × r × t
Simple Interest Example
If you deposit $10,000 in an account with 5% simple interest for 10 years:
- Year 1: $10,000 × 0.05 = $500 interest
- Year 2: $10,000 × 0.05 = $500 interest
- Year 10: $10,000 × 0.05 = $500 interest
- Total after 10 years: $15,000
What Is Compound Interest?
Compound interest is calculated on both the principal AND all previously earned interest. This creates exponential growth as your interest earns interest.
A = P(1 + r/n)^(nt)
Where:
A = Final amount
P = Principal
r = Annual rate
n = Compounding frequency
t = Time in years
Compound Interest Example
Same $10,000 at 5% compounded annually for 10 years:
- Year 1: $10,000 × 1.05 = $10,500 (+$500)
- Year 2: $10,500 × 1.05 = $11,025 (+$525)
- Year 10: $15,513.28 (+$776.28 in year 10 alone)
- Total after 10 years: $16,288.95
Side-by-Side Comparison
| Factor | Simple Interest | Compound Interest |
|---|---|---|
| Calculation Base | Principal only | Principal + accumulated interest |
| Growth Rate | Linear (constant) | Exponential (accelerating) |
| Best For Savers | Never preferred | Always better |
| Best For Borrowers | Always better | More expensive |
| Common Uses | Short-term loans, some bonds | Savings accounts, mortgages, investments |
The Power of Compounding Frequency
How often interest compounds makes a significant difference. Common frequencies include:
- Annual (n=1): Once per year
- Quarterly (n=4): Four times per year
- Monthly (n=12): Twelve times per year
- Daily (n=365): Every day
- Annual compounding: $16,288.95
- Monthly compounding: $16,470.09
- Daily compounding: $16,486.65
Long-Term Impact: 20 and 30 Years
The difference between simple and compound interest becomes massive over longer periods:
$10,000 at 5% for 30 years:
- Simple Interest: $25,000
- Compound Interest (annual): $43,219.42
- Difference: $18,219.42 (72.9% more!)
When Simple vs Compound Interest Applies
Simple Interest is Used For:
- Short-term personal loans
- Some auto loans
- Certain bonds (pay interest periodically)
- Simple promissory notes
Compound Interest is Used For:
- Savings accounts and CDs
- Mortgages and home equity loans
- Credit cards (compounded daily!)
- Student loans
- Investment accounts
- Retirement accounts (401k, IRA)
Strategic Implications
For Savers and Investors
- Start early: Compound interest rewards time more than anything else
- Be consistent: Regular contributions amplify compounding effects
- Reinvest earnings: Never withdraw interest if possible - let it compound
- Seek higher frequencies: Choose accounts with daily or monthly compounding
For Borrowers
- Pay more than minimum: This reduces the principal faster, limiting compound interest
- Make payments early: On compound interest loans, pay before the compounding date
- Avoid revolving debt: Credit cards compound daily, making them extremely expensive
- Refinance when beneficial: Lower rates significantly reduce compound interest costs
The Rule of 72
A quick way to estimate how long it takes to double your money with compound interest:
Years to double = 72 ÷ Interest Rate
Examples:
• 6% interest: 72 ÷ 6 = 12 years to double
• 8% interest: 72 ÷ 8 = 9 years to double
• 3% interest: 72 ÷ 3 = 24 years to double
Key Takeaways
- Compound interest grows exponentially; simple interest grows linearly
- The difference becomes dramatic over longer time periods
- More frequent compounding increases returns
- For savings: Always choose compound interest
- For debt: Simple interest is better, but most loans use compound
- Time is your most powerful tool with compound interest
Understanding the difference between simple and compound interest is essential for financial success. Use our compound interest calculator to see exactly how much difference compounding makes for your specific situation.