Compound Interest vs Simple Interest
Understanding the difference between compound and simple interest is fundamental to making smart financial decisions. Simple interest is calculated only on the principal, while compound interest is calculated on the principal plus accumulated interest — leading to exponential growth over time.
Simple Interest
Simple interest is calculated only on the original principal amount. The interest earned each period stays the same.
I = P × r × t- •Interest calculated only on the original principal
- •Interest amount stays constant each period
- •Linear growth over time
- •Common in short-term loans and car loans
Compound Interest
Compound interest is calculated on the principal plus all previously accumulated interest. This creates an exponential growth effect often called "interest on interest."
A = P(1 + r/n)^(nt)- •Interest calculated on principal + accumulated interest
- •Interest amount grows each period
- •Exponential growth over time
- •Common in savings accounts, mortgages, and investments
Key Differences
| Aspect | Simple Interest | Compound Interest |
|---|---|---|
| Growth Pattern | Linear (constant) | Exponential (accelerating) |
| Interest Basis | Principal only | Principal + accumulated interest |
| Long-term Earnings | Lower | Significantly higher |
| Complexity | Simple formula | More complex calculation |
| Common Use | Short-term loans | Savings, investments, mortgages |
| Example: $10k at 5% for 10yr | $5,000 interest | $6,289 interest |
When to Use Each
Use simple interest calculators for short-term personal or car loans. Use compound interest calculators for savings projections, investment planning, retirement calculations, and understanding mortgage costs.
Frequently Asked Questions
Which is better, simple or compound interest?
For borrowers, simple interest is better because you pay less. For savers/investors, compound interest is better because you earn more. The difference grows dramatically over longer time periods.
How much more does compound interest earn?
On $10,000 at 5% for 10 years: simple interest earns $5,000 while compound interest (monthly) earns $6,470 — a 29% difference. Over 30 years, the gap widens to 150% or more.
Do banks use simple or compound interest?
Most savings accounts use compound interest (daily or monthly compounding). Most car loans use simple interest. Mortgages use compound interest on the remaining balance.