WTFinance is the difference between simple interest vs. compound interest?

The unknown is a funny thing. You may be inclined to shrink away from it—or face it head on. Fear of the unknown lights a fire under me. I want to be the master of my money, and I want to understand what goes on behind the scenes when I’m weighing my options. Since you’re reading this, that fire is probably under you right now. 

Complex financial concepts such as simple interest and compound interest shouldn’t stymie anyone from making educated decisions when borrowing money. You can wrap your brain around this and make more informed choices as a result.

Here’s the gist. When related to debt:

• Compound interest: Often charged on credit cards and bad for consumers.

• Simple interest: Often charged on installment loans and good for consumers.

Compound interest

Compound interest on credit cards is bad because if you don’t pay your balance in full each month, then interest is added to what you owe. And then next month,  interest is charged on your new, higher, total. Over time, that can add up—big time. Compound interest is interest on interest. Credit cards usually charge compound interest. Most add interest to your balance every day. 

Compound interest is good for savers. When you’re saving money, compound interest is a good thing for the exact same reason that it’s bad when you owe. You get paid interest, making your balance bigger. Then you get paid interest on the bigger balance. Interest on interest can help you earn more money.

Simple interest

Simple interest on loans is good because the lender will charge you interest on the principal balance (the amount you borrowed). The lender calculates your interest and adds it to the amount you borrowed. They divide the grand total into equal payments for a set number of months. 

Simple interest is a straightforward and transparent way of charging interest, and it allows you to have predictable payments over the long term.

Compound interest vs simple interest

Let’s say you have two debts. One is a $10,000 personal loan at 12% interest. The other is a $10,000 credit card balance, also at 12%, but the interest compounds daily.

At the end of the first month, you’ll owe $100 in interest on the loan. But you’ll owe $102.42 on the credit card debt.

Compound interest isn’t going to blow your mind until more time goes by. After one year, the $10,000 credit card balance could cost you an extra $78. By the end of three years, you’re losing more than $1,300. 

There are things you can do to save on compound interest, including moving your debts from credit cards to a personal loan if you qualify.