Simple vs Compound Interest
Complete guide to understanding the difference and maximizing your returns
When borrowing money or saving for your future, understanding how interest works is crucial. Two main methods calculate interest: simple interest and compound interest. While they may sound similar, they have dramatically different outcomes over time.
Simple interest is straightforward—you earn (or pay) interest only on your original principal. Compound interest, on the other hand, is "interest on interest." As your balance grows, you earn interest on the growing amount, creating exponential growth. This difference explains why millionaires love compound interest and why credit card companies push it on borrowers.
In this guide, we'll explore both methods with real examples, show you the formulas, and help you understand which scenario applies to your financial decisions.
Quick Comparison Table
| Feature | Simple Interest | Compound Interest |
|---|---|---|
| Formula | I = P × R × T | A = P(1 + r/n)^(nt) |
| Growth Pattern | Linear (straight line) | Exponential (curved) |
| Interest On | Principal only | Principal + accumulated interest |
| Calculation | Easy (basic multiplication) | Complex (involves exponents) |
| Best For | Short-term loans, car loans | Savings, investments, mortgages |
| Long-term Growth | Slower | Significantly faster |
Real-World Examples
Example 1: $10,000 Savings at 5% for 10 Years
Simple Interest Calculation:
I = $10,000 × 0.05 × 10
I = $5,000
Total Amount: $15,000
Compound Interest Calculation (compounded annually):
A = $10,000(1 + 0.05)^10
A = $10,000 × 1.6289
Total Amount: $16,289
Difference: Compound interest earns $1,289 more ($16,289 vs $15,000) over 10 years.
Example 2: $5,000 Car Loan at 6% for 5 Years
Simple Interest (what you pay):
I = $1,500
Total Repayment: $6,500
Most car loans use simple interest or amortization, making them more predictable and affordable than compound interest.
Example 3: $1,000 Credit Card Balance at 20% APR for 1 Year
Compound Interest (compounded monthly):
A = $1,000(1 + 0.20/12)^12
A = $1,000 × 1.2194
Total Owed: $1,219.39
That's $219.39 in interest on $1,000—nearly 22% when compounded. This is why paying off credit card debt quickly is critical.
How Each Type Works
Simple Interest
Simple interest calculates interest only on the principal amount. Once calculated, the interest remains static throughout the loan or investment period. The formula is:
Where:
I = Interest earned or paid
P = Principal amount
R = Annual interest rate (as a decimal)
T = Time in years
Simple interest grows linearly. If you earn $100 in year 1, you'll earn exactly $100 in year 2, year 3, and so on. This predictability makes simple interest common for short-term loans like car loans and mortgages (which use amortization, a variant of simple interest).
Compound Interest
Compound interest calculates interest on both the principal and previously earned interest. This creates exponential growth because each period adds interest to a larger base. The formula is:
Where:
A = Final amount
P = Principal amount
r = Annual interest rate (as a decimal)
n = Number of times interest compounds per year
t = Time in years
Compound interest grows exponentially. In year 1, you might earn $100. In year 2, you earn interest on $100 + the principal. By year 10, each year's interest is significantly larger than the previous year. This "snowball effect" is why Albert Einstein allegedly called compound interest the eighth wonder of the world.
5 Key Differences
1. Growth Pattern
Simple interest grows linearly (straight line on a graph). Compound interest grows exponentially (curved line that steepens over time).
2. Interest Calculation
Simple interest always calculates from the original principal. Compound interest recalculates on the growing balance.
3. Complexity
Simple interest is easy to calculate by hand. Compound interest requires exponents and is best calculated with a calculator.
4. Long-term Impact
Over short periods (1-3 years), the difference is small. Over decades, compound interest vastly outpaces simple interest.
5. Real-World Use
Simple interest: car loans, short-term personal loans. Compound interest: savings accounts, credit cards, stocks, long-term investments.
Frequently Asked Questions
Which type of interest is better for borrowers?
Simple interest is better for borrowers because less interest accrues over time. Compound interest is better for savers and investors because their money grows faster.
Can you earn compound interest on a savings account?
Yes! Most savings accounts, money market accounts, and CDs use compound interest, typically compounded daily or monthly. Check with your bank for the compounding frequency.
How often is compound interest compounded?
Common compounding frequencies include annual, semi-annual, quarterly, monthly, weekly, and daily. More frequent compounding results in higher returns.
What is the Rule of 72?
The Rule of 72 estimates how long it takes for an investment to double: divide 72 by the annual interest rate. For example, at 8% annual return, your money doubles in approximately 9 years (72 ÷ 8 = 9).
Does credit card debt use simple or compound interest?
Credit cards typically use compound interest, compounded daily. This is why credit card debt grows so quickly and can become expensive if not paid off promptly.
Which formula is easier to calculate?
Simple interest is easier to calculate manually because it uses a straightforward linear formula. Compound interest requires exponents or logarithms, so a calculator is helpful.
Related Calculators
Key Takeaways
- ✅ Simple interest earns/charges interest on principal only; compound interest earns interest on interest
- ✅ Compound interest grows exponentially; simple interest grows linearly
- ✅ For savers: compound interest is your friend—start investing early
- ✅ For borrowers: simple interest is better—pay off compound interest debt quickly
- ✅ Time is the most powerful variable—small differences compound dramatically over decades