Interest can be simple or compound, which changes its calculation and how much you can expect to pay or earn. Simple interest is straightforward, applying only to the principal amount you borrow or deposit, while compound interest applies to both the principal and the interest that accrues on this amount.
Read on to learn more about simple vs. compound interest and the differences between the two so you can make the best choice among financial products.
Simple Interest vs. Compound Interest at a Glance
- Simple interest applies only to a financial product's principal (the amount you borrow or deposit), while compound interest applies to principal and accrued interest.
- Calculating the amount of interest you'll owe or receive depends on the type of interest associated with the account in question.
- Simple interest is largely preferable when borrowing money since it reduces the amount you'll owe over time, while compound interest benefits investors as it increases the amount you'll earn on those accounts.
- Compound interest can grow at different rates, depending on how often interest compounds (daily, quarterly, or yearly), while simple interest is typically expressed as an annual percentage rate (APR).
What Is Interest?
When you borrow money, you will almost always have to pay a fee in addition to repaying what you borrowed. Interest is the surcharge associated with repaying borrowed funds, typically represented as a percentage of what you borrow.
You’ll find interest on most financial products, whether you are the borrower taking out a loan for a car, home, or personal expense or a lender investing in a certificate of deposit (CD) or high-yield savings account.
However, calculating the interest you owe — or are owed — depends on the type of interest associated with the account, which could be simple or compound.
Types of Interest
Simple Interest
Simple interest is as straightforward as it sounds and much easier to calculate.
“It’s calculated only on the original amount, called the principal,” says Baruch Mann (Silvermann), financial expert and CEO of The Smart Investor.
That means you only pay simple interest on the amount you borrowed or invested — not on any interest you accrue along the way. While your interest rate could be fixed or variable (meaning it may or may not change throughout the life of your loan), your payments will be relatively uniform with this type of repayment.
“You most often see simple interest at work with consumer loans (home, auto, personal loans),” says Patrick Sabol, certified financial planner (CFP) and senior lead planner at Facet.
Simple interest is common with these types of loans because it results in straightforward monthly payments that the borrower can easily plan for.
Simple Interest Formula
To calculate simple interest, you’ll need to know your principal amount, annual interest rate, and the term of your loan.
“Simple interest is calculated annually based on the principal balance only,” explains Laura Sterling, vice president of marketing at Georgia's Own Credit Union. “The formula for simple interest is I = P*r*t. In the formula, P is the total principal, r is the interest rate, and t is the term.”
Simple Interest Example
Say you take out a loan for a new car. You borrow $20,000 at a 4% interest rate with a five-year term. To calculate your interest, multiply the principal amount by the rate and term.
$20,000 x 0.04 x 5 = $4,000
Over the life of the loan, you will be charged a total of $4,000 in simple interest, making the total amount you repay $24,000.
Compound Interest
Compound interest is a bit more complicated than simple interest, as it builds on itself (compounds).
“Compound interest is interest on both the principal and the interest that’s already been added,” says Mann.
Because compound interest grows over time, it is more common with investment products — allowing investors to yield higher returns — and less common on loans.
“You see compound interest at work with fixed income products such as CDs and bonds (most CDs compound daily or monthly, and bonds generally every six months) which can be a good investment for short-term savings goals or for investors seeking income over growth,” says Sabol.
Still, some borrowing options, including credit cards, come with compound interest.
Compound Interest Formula
Calculating compound interest can be a bit more complicated than simple interest.
“It can be calculated daily, monthly, quarterly, or annually,” said Sterling.
“The formula for compound interest is A=P(1+r/n)nt. In the formula, P is the total principal, r is the interest rate, n is the length of the term, expressed in years, and t is the number of years,” she adds.
Compound Interest Example
To calculate compound interest, you’ll need to know your current balance and interest rate, just like with simple interest. But unlike simple interest, compound interest earnings will apply to the interest as well.
“For example, if you invest $10,000 at a 4% compound interest rate, you’ll earn $400 in the first year. But in the second year, you earn interest on $10,400, so you’ll get $416, and it keeps growing,” says Mann.
Simple Interest vs. Compound Interest: Key Differences
The most fundamental difference between simple and compound interest is that simple interest only applies to the principal amount, while compound interest applies to the principal plus interest. Other variances between the two types of interest include:
- Compound interest can grow at different rates. With simple interest, you will typically earn (or be charged) an annual percentage rate, and since the principal amount doesn’t change, the interest won’t either. With compound interest, the amount you earn will depend on how often interest is compounded. This could be daily, monthly, quarterly, or annually, depending on the financial product.
- Simple interest is more favorable for borrowers. The straightforward formula and predictable payments associated with simple interest make it the better option for most loans. That is because compounding interest could result in you paying more over time.
- Compound interest is more favorable for lenders. The compounding nature of compound interest yields higher charges — and higher returns for the lender. That makes it the better option for most savings and investment products, especially if you plan to invest over a long period of time.
Simple or Compound Interest: Which Is Better?
Simple interest may be easier to understand, but compound interest often yields higher returns. Most generally, simple interest is more beneficial when you are borrowing money, while compound interest is beneficial when you are lending money, though there may be a few exceptions.
"If you are getting a loan, simple interest loans generally mean you will pay less interest over the life of the loan," Sterling says. "Simple interest loans are also good for borrowers who want a straightforward payment structure. On the flip side, a compound-interest loan could provide a better interest rate and save you less in the long run if you are able to pay it off quickly. If you are opening a deposit account, you'll generally earn more with compound interest."
Sabol added that while it can take time to see compound interest's benefits, it is usually worth the long-term investment.
Compare top online bank accounts with compounding interest today.
