Simple vs. Compound Interest: Understand the Difference & Impact

Interest is expected when you take out a loan or when you make an investment. Understanding the difference between simple interest vs. compound interest is a step forward in increasing your financial awareness.

Read more to learn the difference between simple and compound interest, and where they’re typically used.

What’s The Difference Between Simple Vs. Compound Interest?

Simple and compound interest are the primary ways to calculate interest on a loan or investment. Simple interest tends to be used for loans and compound interest tends to be used for investments. For mathematical comparison, this article will use them both in loans and investments, though you may not see them used that way in the real world.

Numerically, the difference between simple and compound interest is that simple interest is a fixed rate based on the principal amount of the loan or deposit, while compound interest represents that same principal rate plus accumulated interest.

A loan with compounding interest will apply new interest to the total amount owed. This compounding may occur monthly, quarterly, semi-annually or annually. This results in you owing more because more interest is charged every time it compounds.

We’ll break it down further. Read on as we compare and contrast simple vs. compound interest.

How Does Simple Interest Work?

Simple interest what you pay on the principal over the term of the loan. If you have a savings account with your bank, it likely has a small, simple interest rate associated with it. Simple interest is also used with certificates of deposit (CDs). These are investments with banks that payout on a specific date.

Simple interest is often confused with APR, or annual percentage rate. The difference between the two is that your simple interest rate only calculates the interest on the loan. APR includes the interest, as well as additional fees on the loan. In general, APR is higher than simple interest as it includes the total cost of the debt.

How Do I Calculate Simple Interest?

Calculating simple interest is relatively … simple. First, you need to understand a few components: principal, interest rate and term of the loan. Your principal is the amount of money you borrowed initially. The interest rate is what you’re essentially charged for borrowing the principal. The term is the length of the life of the loan, or how much time you have to pay it back.

To calculate the total interest you will pay, you multiply your principal by your interest rate by the number of years on the loan. The standard formula is:

Principal x Interest Rate x Term = Total Interest Paid

Let’s use an example. You take a $15,000 car loan out at a rate of 4.5% to be repaid over 5.5 years (66 months). The $15,000 is your principal – the original amount you owe. The 5.5 years is the term of the loan.

15,000 x 0.045 x 5.5 = total interest paid

15,000 x 0.045 x 5.5 = $3,712.50

If you add this to your $15,000 loan, the total you will pay in principal and interest is $18,712.50.

When Does Simple Interest Help My Finances?

Simple interest keeps interest rates low, which causes less interest to paid on debts, but also less interest paid out on investments. In general, simple interest is much easier to understand than compound interest. Here’s where you’ll see simple interest most often applied:

• CDs
• Consumer loans
• Car loans
• Student loans

Technically, mortgages are loans with simple interest, however, because of amortization, mortgages function differently than other simple interest loans.

How Does Compound Interest Work?

Compound interest is interest that builds over the term of the loan or length the investment is held. The rate at which it compounds determines how much interest builds. In terms of a loan, any unpaid interest at the end of a period is factored into the next month. APY, or annual percentage yield, is the total amount of interest you’ll pay over the course of the loan.

Compound interest is also used in investments, such as retirement accounts. Say you make a $1,000 investment that compounds at 4% yearly. At the end of one year, that investment would be $1,040. The next year, the $1,040 compounds by 4% to $1,081.60. As long as the investment is held, the amount grows exponentially over the years. If you hold this investment for 10 years and it continues to grow at 4%, it will grow to $1,790.85.

How Do I Calculate Compound Interest?

Calculating compound interest is more complicated than calculating simple interest. Here’s the formula:

I = P [(1 + r)n -1]

 

I = total compound interest

P = principal or initial investment

r = interest rate per compounding periods

n = number of compounding periods

Say you take out a $5,000 loan at a 5.5% interest rate that compounds twice annually. You pay this loan off over 5 years. What will you end up paying in compound interest?

P = 5000

r = 0.055

n = 10 (5 years compound twice each year)

Here’s the solve in a few steps:

I = 5000 [(1 + 0.055)10 – 1]

5000 [(1.05510 – 1]

5000 [1.708 – 1]

5000 * 0.708 = 3,540

After 5 years of paying off this $5,000 loan, an additional $3,540 will be paid to compounding interest, making the total amount paid $8,540. By comparison, a loan with simple interest would only pay $1,375.

When Does Compound Interest Help My Finances?

Compound interest is going to be the best for you when it’s in reference to an investment, not a debt. Compound interest is particularly helpful in investment accounts.

You may have heard the advice that investing in retirement should be started young. This is true in part because of compounding interest. The earlier you have money in an account that compounds, the more compounding periods you’ll have to take advantage of.

Specific investments like bonds, index funds, and high-interest savings accounts are other places where you’ll see compounding interest.

Why Does Simple Interest Vs. Compound Interest Matter?

Simple and compound interest are two different ways interest can build. The difference matters because building interest can be either a big negative, in terms of a loan, or a big positive, in terms of an investment.

To show you the variance between compound and simple interest, let’s work through a fictional example of a loan. This loan is for $200,000 over 15 years at 2.72%. We’ll plug these figures into our formulas presented above to find the total simple and compound interest for the same loan principal.

Total simple interest paid on this loan is $81,600. If you were to pay compound interest, compounding yearly, the total interest paid would be $99,126.68, which is $17,526.68 more than the simple interest amount.

While you may not see a loan that compounds like this in real life, this example is helpful to illustrate the difference.

The Bottom Line

In the U.S., banks are legally required to be transparent about interest charges. You should know going into an investment or a loan whether it’s simple interest or compound interest that’s being talked about.

While in general, compound interest refers to investments and simple interest refers to loans, there are exceptions to this. Knowing how the interest works could save you – or make you – a lot of money.

Review how to grow your savings and make wise investments using the power of interest.