Simple Interest vs Compound Interest

Simple interest and compound interest are the two types of interest that impact financing, savings and investment accounts. You can make smarter financial decisions by understanding simple interest vs compound interest and how they’re calculated.

What is interest?

Before we take a closer look at the difference between simple interest and compound interest, let’s define interest. Interest is the price you pay to borrow money—or the return you earn on an investment. Any time you take out a loan, you’re usually required to pay it back with interest on top of the principal or the amount you’ve borrowed. On the other hand, you may earn interest when you invest money in an account like a traditional or high-yield savings account or buy a savings bond for example.

It’s common to get the interest rate and the annual percentage rate (APR) mixed up when you apply for a loan or line of credit. The APR includes the interest rate as well as any fees or extra costs tied to the loan, which gives you a clear picture of what you'll actually be paying each month.

Another term to understand is the annual percentage yield (APY) which tells you how much interest you can earn on your money in a year. The APY factors in how often the interest compounds, whether it’s daily, monthly or quarterly, giving you a better sense of how much your savings can grow over time.

What is simple interest?

Simple interest is interest that borrowers pay lenders for a loan or what banks pay customers on their savings accounts.² Typically, you’ll pay simple interest on common loans, like mortgages, auto loans and personal loans. Your monthly payments will include the interest you owe, but with simple interest, it’s only calculated on the remaining loan balance (principal balance). Your lender splits your payment amount between the interest owed and the remaining loan amount. As you continue to pay on time each month, the interest charges will decrease as your principal balance gets smaller.

How to calculate simple interest

To calculate simple interest, you’ll need to know the principal balance, interest rate and term, which is the length of time the loan lasts. Here’s the simple interest formula you can use:³

Principal (Initial Balance) x Interest Rate x Time

Let’s say you take out a $10,000 personal loan with an interest rate of 18% and a 5-year term. To figure out how much interest you’ll pay over the life of the loan, you’d calculate: $10,000 X 0.18 X 5 years. So, you’d pay $9,000 in total interest charges.

What is compound interest?

Compound interest applies interest to the principal balance and the interest that’s already started to accrue. It’s interest that you earn or have to pay on top of the existing interest and principal. If you choose a credit card or loan with compound interest, you can expect to pay more in interest over time.⁴

When it comes to savings and investment accounts, compound interest can be an invaluable tool that allows you to build wealth. Since you’ll earn interest on interest, your savings account, certificate of deposit (CD) or money market account, for example, will grow quicker.

How to calculate compound interest

Compared to the simple interest formula, the compound interest formula is a bit more complicated because it includes how often during the year interest compounds. Here’s the compound interest formula you can use to calculate it:⁵

A = P (1+r/n) nt
A = Total amount (principal + interest)
P = Principal balance (the original amount)
r = Interest rate
n = number of times interest is compounded per year
t = number of years the interest is being applied

For example, say you deposit $5,000 in a savings account that earns a 3% APY and compounds monthly. You’d calculate A = $5,000(1 + 0.03/12)^{12 x} and your ending balance would be $5,152. After a year, you’d have a balance of $5,152 in the savings account.

Simple interest vs compound interest: Which is best?

Now that we’ve gone over the definitions and calculations of simple interest and compound interest, you may wonder which type of interest is better. The answer depends on how you’re using your money. If you take out a loan, simple interest is a good choice because it will allow you to pay less in interest charges in the long run.

On the flip side, compound interest benefits you when you open a savings or investment account, like a certificate of deposit (CD), money market account or Roth IRA. You’ll earn interest on the interest that already grows in your account and enjoy a bigger balance as a result.⁶

How to save money and maximize your earnings

If your goal is to lower your overall cost of borrowing on a loan, it’s a good idea to check interest rates with different lenders to compare your options. Some lenders may provide you with your potential rates before applying, while others may not. It’s also important to note that each state has different laws governing the maximum interest rate that lenders can charge borrowers. A lower rate can lead to hundreds or even thousands of dollars in savings depending on the loan amount.

When you shop for savings or investment options, make sure the accounts you choose use compound interest rates. A higher compound interest rate can make it easier for you to meet (or even exceed) your savings goals over time.

Make smart money moves with interest

Before you take out a loan or stash your money into a savings account, you should determine which one best fits: simple or compound interest. This way you can calculate your potential costs and earnings and compare all the options to determine which best fits your budget and lifestyle.

Sources

1 Interest: Definition and Types of Fees For Borrowing Money. Investopedia
2,3,4,5 Simple vs. Compound Interest: Definition and Formulas. Investopedia
6 What is the Difference Between Simple & Compound Interest?. The Motley Fool