Simple interest calculates earnings or payments based solely on the initial principal, while compound interest grows by calculating interest on both the principal and the accumulated interest over time.
Whether you’re taking out a line of credit or making an investment, you’ll want to know as much as possible about interest before you commit. But not all interest rates are the same.
In the world of finance, you’ll run into two types of interest: simple and compounding. Here’s a helpful overview of simple interest vs. compound interest.
What is Simple Interest?
Simple interest is based only on the principal amount of a loan or investment. In other words, you won’t be charged interest on the interest that accrues.
You usually see this type of interest on car loans and mortgages. Because the interest rate is a percentage of the remaining principal, you pay less interest as the loan balance decreases.
Pros:
- If you’re borrowing money, you’ll likely pay less over time
- As the amount of initial principal decreases, so does the amount of interest
- You can reduce the total interest you pay by making larger installment payments
Cons:
- Earns less over time than an account with compound interest
- Often come with substantial fees for missed or late payments
You’ll want to pay close attention to the interest rate, regardless of whether you’re opening a savings account or taking out a car loan.
With all other things being equal, a simple interest loan usually results in you paying less interest than a compound interest loan. But if you get a simple interest loan with a high interest rate, you might end up paying more.
Formula for Calculating Simple Interest
The simple interest formula is as follows:
Interest paid = Principal x Interest rate x Time period
For example, let’s say you take out a $10,000 loan with an interest rate of 10% per year and a loan term of five years.
To get the total simple interest you’d pay over the life of the loan, you’d multiply $10,000 x 0.10 x 5 to get $5,000. Over the life of this loan, you would pay $5,000 in interest or $15,000 total.
What is Compound Interest?
Unlike simple interest, compound interest isn’t based solely on the initial principal (or the initial deposit into an investment account). Essentially, compound interest accumulates interest on interest as well as on the principal.
Some savings accounts and similar investment accounts use compound interest, which is one thing that makes them so attractive to potential account owners. Over time, a savings account using compound interest will grow much larger than one with simple interest.
Compound interest is also what makes credit card debt so difficult to get out of. If you’re charged interest on both the things you buy and the interest you accrue over time, you’ll end up paying substantially more than the cost of your initial purchases if you carry a balance.
Pros:
- Helps you earn more over time if you’re opening an investment account
- Investing in an account with compounding interest can deliver major returns
Cons:
- Cost of compound interest is often more than it seems
- Compounding effect can make it significantly harder to pay off debt
Understanding compound interest and its long-term effects can help you make smart decisions for your financial future. Benzinga offers a wealth of free resources to help you learn everything you need to know.
Formula for Calculating Compound Interest
When you look at the formulas for simple interest vs. compound interest, you’ll see that the compound interest formula is a little more complicated. It looks like this:
A = P(1 + r/n)nt
Don’t freak out if math isn’t your strong suit. Here’s what the variables mean:
- A: Accrued amount, meaning principal plus interest
- P: Amount of principal
- r: Interest rate
- n: Number of times the interest rate is applied over a given period
- t: Number of periods that have passed
As an example, let’s say you take out a small loan of $1,000. The loan has an interest rate of 5% compounding each year, and the loan term is two years. To find the accrued amount (what you’ll pay in principal plus interest), you’d plug in the numbers and get this:
1,000(1 + .05)2
That gives you an accrued amount of $1,102.50. Because your principal amount is $1,000, you’ll pay a total of $102.50 in compounding interest.
Comparing Simple Interest vs. Compound Interest
Hopefully, some of these distinctions are starting to make sense. To ensure that they sink in, here’s a closer look at the important differences between simple and compound interest.
Rate of Interest
An interest rate is the amount a lender charges to borrow money (or the return on investment you get from a savings account or similar investment account). It’s expressed as a percentage of the initial investment or amount borrowed.
If you’re borrowing money, higher interest rates mean you’ll pay more over time. A car loan with 3% interest is much better than one with 10% interest.
If you’re investing money, on the other hand, higher interest rates mean you’ll earn more over time. In this case, a savings account with 4% interest is preferable to one with 1% interest.
Time
With any type of loan or investment, interest accumulates over time. But time has different effects depending on the type of interest applied.
For example, let’s say you deposit $10,000 in an account with a simple interest rate of 3% per year. After 40 years, you’d have $22,000 in the account. Not bad, right?
Now let’s say you put $10,000 in an account with 3% interest compounding annually. After 40 years, you’d have $32,620.38. Big difference.
Compounding Frequency
You know that with compound interest, you end up paying (or earning) interest calculated from the principal plus any interest that’s already accrued. Each time interest compounds, you’re charged more interest.
As a result, compounding frequency is a key variable to consider. Interest may compound annually, quarterly, monthly or daily. The more frequently it’s compounded, the more interest accumulates.
Understanding the Practical Applications
Looking at formulas for simple and compound interest might seem like an abstract exercise, but it has real, practical applications.
For instance, if you want to open a savings account, don’t just choose the first one you see. Some savings accounts offer simple interest. Others offer compound interest. It might seem like a small detail, but over time, the account with compound interest will give you a much better return on your investment.
Any time you’re investing or taking out a loan, remember this helpful rule of thumb: simple interest is advantageous when you borrow money, and compound interest is advantageous when you make an investment.
Know How Interest Impacts You
Knowing how simple interest vs. compound interest works is an important part of financial literacy — understanding this seemingly small distinction can make a major difference in your future financial decisions.
If you want to build even greater financial literacy, Benzinga can help. You’ll find tons of articles and guides written by experts, and you can also follow financial and investment news and learn from the free forums. Spending a little time learning can really pay off.
Frequently Asked Questions
Do banks use simple or compound interest?
When it comes to investment products like savings accounts or certificates of deposit (CDs), banks almost always use compound interest. For loans, however, they may use simple or compound interest.
Simple interest or compound interest: which is better?
It depends on whether you’re saving money or borrowing it. If you’re putting money in a CD or savings account, compounding interest will earn you more over time. But if you’re borrowing money, you’ll pay less over the loan term with simple interest.
What is an example of simple and compound interest?
Simple interest is typically used for car loans, mortgages and student loans, while compound interest is generally used for credit cards and investments (like savings accounts).
About Sarah Edwards
Sarah Edwards is a finance writer passionate about helping people learn more about what’s needed to achieve their financial goals. She has nearly a decade of writing experience focused on budgeting, investment strategies, retirement and industry trends. Her work has been published on NerdWallet and FinImpact.