Image
Simple Interest vs. Compound Interest: What’s the Difference?
Understanding interest can boost your financial confidence and help you make informed decisions about borrowing and saving. In this article, we’ll explain simple and compound interest rates, how to calculate them, and their impact on your finances.
What is simple interest?
Simple interest is a fixed rate calculated only on the principal amount of a loan or deposit.
Formula for simple interest
The formula for simple interest is straightforward: principal amount x interest rate x time.
For example, let’s say you deposit $1,000 into a savings account with a 5% annual interest rate and make no additional deposits. First, convert 5% to a decimal (0.05), then calculate the interest earned in one year as follows:
$1,000 x 0.05 x 1 = $50
In this scenario, you’ll earn $50 of simple interest each year without any additional deposits.
What is compound interest?
Compound interest is calculated on the initial principal plus any accumulated interest. This means your savings can grow rapidly, or debt can increase significantly over time. We’ll show examples of compound interest's effects on loans and savings later.
Formula for compound interest
The formula for compound interest is more complex than for simple interest because it involves exponents. I recommend using an online calculator to determine how much compound interest you’ll either pay on a loan or earn in an investment account.
To use a compound interest calculator, you'll need the principal amount, interest rate, number of years, and compounding frequency.
For example, if you enter $1,000 as the principal, 1 year, 5% annual interest rate, and select “compound monthly,” you’ll see you earn $51.16 in a compound savings account in one year.
Unlike simple interest, compound interest means you earn interest on both your original $1,000 and the $51.16 earned in the first year. Each year, your interest grows, even without additional deposits.
Is simple or compound interest better?
For saving money, compound interest is better because your money earns interest on your principal and interest you’ve already earned. Even without additional deposits, you'll earn more with a compound interest account than with a simple interest account at the same rate.
For loans, simple interest is better because you'll pay less interest over the life of the loan. The difference is significant for large loans paid over several years.
Examples of simple and compound interest
Until I started running the numbers, I didn’t know how much difference there was between simple and compound interest. It turns out there’s a significant difference, especially over time.
Simple vs. compound interest for savings
Let's compare simple and compound interest for a $1,000 savings account with a 5% interest rate and no additional deposits over five years.
Image
With compound interest, you'll have $33.36 more after five years than with simple interest. Over 10 years, the difference grows to $174.01.
Simple vs. compound interest for borrowing
Now let’s compare the effects of simple vs. compound interest when you’re borrowing money. We'll use an example of a $1,000 loan with 5% yearly interest, a one-year repayment period, and monthly payments of $85.61.
- Simple interest loan: Total payment = $1,026.46 ($1,000 principal + $26.46 interest)
- Compound interest loan: Total payment = $1027.29 ($1,000 principal + $27.29 interest)
While this difference seems small, it grows with longer repayment periods.
Two-year repayment period (monthly payments of $43.87):
- Simple interest: Total payment = $1,049.59 ($1,000 principal + $49.59 interest)
- Compound interest: Total payment = $1,052.92 ($1,000 principal + $52.92 interest)
Three-year repayment period (monthly payments of $29.97):
- Simple interest: Total payment = $1,071.61 ($1,000 principal + $71.61 interest)
- Compound interest: Total payment = $1,078.95 ($1,000 principal + $78.95 interest)
The longer a loan takes to pay off, the more interest you’ll pay, with compound interest resulting in the highest total cost.
Do banks use simple or compound interest?
Most banks use compound interest for their products. Loans with compound interest benefit banks, and investment accounts with compound interest benefit customers. Some basic savings accounts or short-term loans may use simple interest, so it's best to ask if you're unsure.
What types of loans use compound interest?
Student loans are a common example of compound-interest loans. These loans allow lenders to get the highest return on their investments, but they’re also more difficult for borrowers to pay off.
Understand your loan or investment’s interest
Knowing the difference between simple and compound interest helps you make informed financial decisions. As we’ve shown, the differences between the two grow more significant over time.
Ready to go beyond simple vs. compound interest? Our article on interest rates and how they work can help you choose your next loan.
