Compound Interest vs Simple Interest
Interest is the cost of borrowing money or the reward for saving it. There are two main types: simple interest and compound interest. Understanding the difference is essential for making informed financial decisions.
What is Simple Interest?
Simple interest is calculated only on the original principal. It does not include previously earned interest. The formula is:
A = P × r × t
Where P is principal, r is rate, and t is time in years.
Simple Interest Example
$1,000 at 5% simple interest for 5 years:
Interest = $1,000 × 0.05 × 5 = $250
Final balance: $1,250
What is Compound Interest?
Compound interest is calculated on the principal plus all accumulated interest. Each period, your balance grows larger, and so does the interest earned.
Compound Interest Example
$1,000 at 5% compound interest (annually) for 5 years:
A = 1000 × (1 + 0.05)5 = $1,276.28
Interest earned: $276.28 — compared to $250 with simple interest.
Side-by-Side Comparison
- Simple Interest (5 years): $1,250.00
- Compound Interest (5 years): $1,276.28
- Compound Interest (20 years): $2,653.30
- Simple Interest (20 years): $2,000.00
Over longer periods, the gap between simple and compound interest becomes enormous.
When is Simple Interest Used?
Simple interest is commonly used for:
- Short-term personal loans
- Auto loans
- Some types of bonds
When is Compound Interest Used?
Compound interest is used in:
- Savings accounts and money market accounts
- Investment portfolios and retirement accounts
- Credit cards and mortgages (where it works against you)
Which is Better for You?
As a saver or investor, compound interest is always preferable — your money grows faster. As a borrower, simple interest loans are cheaper because you only pay interest on the original principal.
Conclusion
The difference between simple and compound interest may seem small in the short term, but it becomes dramatic over time. Always seek compound interest when saving and investing, and be cautious of it when borrowing. Use our compound interest calculator to visualize the difference for your own financial goals.