Simple vs. Compound Interest: Here's What You Need to Know
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When you stash your money in savings at a bank or credit union, the financial institution pays you interest—free money you receive every month.
But you also see interest rates when you’re looking to borrow. That new credit card, your mortgage, a student loan — all of them come with an interest rate that lets you know how much you’ll pay your lender.
When you’re on the receiving end of interest, higher is generally better, since you’ll typically earn more per dollar. And when you’re borrowing, you’ll typically want a low-interest rate, so you’ll spend less money repaying the loan.
But there’s another factor at play. And that’s simple interest vs. compound interest. What’s the difference? Where do they crop up in the world of finance? And what do you need to know about compound and simple interest to make the best decisions for your money?
What is simple interest?
Simple interest is earned solely from the principal amount—the amount you save in a savings account or the value of the loan you take out. You’ll find simple interest used in most home mortgages, car loans, and even store finance loans.
Calculating simple interest is straightforward. You can crunch your own numbers by hand with this basic formula:
Interest = P x R x T,
where P is the principal, R is the interest rate, and T is the amount of time (given in years).
So, for instance, if you save $1000 in an account with a simple interest rate of 2%, you’ll earn $20 in interest after one year:
Interest = $1000 x 0.02 x 1 = $20
In fact, every year, you’ll earn exactly $20 of interest. So, after Year 2, you’ll have $40 of interest:
Interest = $1000 x 0.02 x 2 = $40
After year 3, it’ll be $60, and so on. On the flip side, if you borrow $1000 at a simple interest rate of 2%, you’ll owe $20 in interest every single year.
Want to see how your money adds up with simple interest? Plug your numbers into this easy simple interest calculator.
What is compound interest?
Compound interest is earned both from the principal amount and the interest that you’ve accumulated at that point. So, instead of earning interest exclusively on the principal, you’re earning interest on the interest as well. You’ll find compound interest used often in finance — in savings accounts at a bank or credit union, credit cards, and student loans, for instance.
Because every interest payment depends on how much interest you’ve already earned, calculating compound interest is more complex than calculating simple interest. The formula looks like this:
Interest = P x (1 + R / N) N x T - P
where P is the principal, R is the interest rate, T is the number of years, and N is the number of compounding periods (that is, the number of times interest compounds each year).
So if you save $1000 in an account with an interest rate of 2% that compounds once a year, you’ll earn $20 in interest after that first year (just as you would with simple interest):
Interest = $1000 x (1 + 0.02 / 1) 1 x 1 - $1000 = $20
After Year 2, however, your total interest earned won’t be $40 but $40.40:
Interest = $1000 x (1 + 0.02 / 1) 1 x 2 - $1000 = $40.40
After Year 3, your total interest will be $61.21. After Year 4, your total interest will be $82.43, and so on.
Want to see how your money adds up with compound interest? Plug your numbers into this easy compound interest calculator.
Simple interest vs. compound interest
The formulas for simple and compound interest are clearly different, but what does that mean for your money?
In a nutshell, compound interest increases more rapidly than simple interest.
And the frequency of compounding matters too. The more often compound interest is calculated — yearly, quarterly, monthly, or daily — the higher your interest will go.
Here’s an example:
You decide to save $1000 in each of three accounts. Account 1 boasts an annual simple interest rate of 2%. Account 2 offers the same 2% interest rate but compounds once a year. And Account 3’s 2% annual interest rate compounds monthly.
Look at what happens to your money after one year, two years, 10 years, 20 years, and even 30 years:
As time goes on, the accounts with compound interest increasingly outpace the earnings of the simple interest account. And the money that’s compounded more frequently earns at a faster rate than the money in the second account.
Compound vs. Simple Interest: The Upshot
Frequent compound interest is a tremendous asset when you’re saving money. And simple interest keeps your monthly interest payments consistent and low when you borrow. So, when you understand the key differences in compound and simple interest, you’re in the best position to evaluate your financial options and make smart choices for your money.