Simple vs. compound interest: what’s the difference?
Key takeaways:
Knowing how interest rates work could help you choose a less costly loan
Compound interest is interest on interest
Simple interest is best for loans
A dollar might not change your life. But a dollar a day might. And if that dollar grows bigger every day, it could make or break your finances.
Compound interest makes the numbers grow more quickly than simple interest. If those numbers represent your savings, great. Compounding is what you want. If we're talking about debt, not so great. Compound interest will cost you more.
This stuff can make our brains hurt, so we asked finance expert and published author Mitchell Weiss to help us break it down. Mitchell helps non-finance people understand finance.
Simple interest vs. compound interest
Interest is the cost of using someone else's money. If you use your credit card issuer's money, you pay interest. If you put money in the bank, they pay you interest.
Simple interest
is calculated on the amount borrowed (the principal balance)
Compound interest
is calculated on both the principal balance and interest that has previously been added
We'll show you some examples using a $10,000 balance and 12% interest. Typical savings accounts don't earn this much, and typical credit cards cost a lot more. But comparing apples to apples will make it easier to recognize how the types of interest affect your finances.
Simple interest
Simple interest is based on the amount borrowed, the interest rate, and time. Simple interest is good for borrowers. The calculation is:
Principal x Interest rate/12 = simple interest paid per month.
Simple interest borrowing example: personal loan
Let's say you take out a personal loan for $10,000 at 12% interest. Your interest charge is 1% per month (1/12th of 12%). At the end of the first month, that's $100, so now you owe $10,100.
If you make a $300.00 payment, your new balance is $9800.00.
In month two, you'll only owe $98 in interest. As your balance goes down, so do your interest charges.
Simple interest savings example: certificate of deposit
Certificates of deposit, or CDs, are an unusual type of savings account in that they pay simple interest. CDs pay a specific amount in interest on a set date, and the money can't be withdrawn until that date.
Invest $10,000 in a one-year CD that pays 12% interest after one year, and you'd earn $1,200 in interest after one year.
$10,000 x 0.12 = $1,200
Your balance would be $11,200.
Compound interest
Compound interest is good when you're saving money. First, you earn interest, which increases your balance. Then you earn interest on the bigger balance. You're earning interest on interest.
It's not so great for debts because you'll pay more interest over time.
Compound interest borrowing example: credit card debt
The interest on credit cards usually compounds daily. If you owe $10,000, you'll owe $102.42 at the end of the first month.
Compared to our simple interest example above, it'll cost you an additional $2.42 for the same loan with compound interest. That doesn't seem like much, but if you think about it in terms of all of your debts, at all of their interest rates, over a span of years…the numbers snowball.
Compound interest savings example: savings account
Here's an example of how compound interest works when you save.
Let's say you invest $10,000 and you earn 12% interest that's compounded monthly (that means the interest is calculated once a month). At the end of one year, you'd have $11,268.25.
Compared to the $11,200 that you earned in the simple interest savings example above, compounding has put you more than $68 ahead.
The beauty of compounding is that you get to earn interest on the higher balance every time interest is added. This is why the proverbial "they" always recommend that you start saving early and leave your money alone so it can grow.
Fun fact: the Rule of 72
You can figure out when your money will double by using the Rule of 72. You just need to know the interest rate. (This rule only works for annual compounding.)
The formula is this:
72 / interest rate = years to double your money
For example, if you expect a 5% rate of return, your money will double in value about every 14 1/2 years.
Frequently asked questions
What is the difference between the interest rate and the APR?
The interest rate is the cost of borrowing money. APR, or annual percentage rate, includes the interest rate and any fees or costs of a loan. An APR is higher than an interest rate if fees are involved.
How do lenders determine interest rates for loans?
A borrower’s credit score is the primary factor lenders consider when they decide what interest rate they will offer you. Generally speaking, people with higher credit scores can get lower interest rates. Other factors that can affect your rate include:
Loan term (shorter terms sometimes qualify for lower rates)
Loan amount (smaller loans sometimes qualify for lower rates)
Economic conditions (when market rates change, lenders change the rates they charge customers)
What’s better, compound, or simple interest?
Compound interest is best for investors and savers because you’ll earn interest on your interest. For borrowers, compound interest can lead to paying more.
Simple interest is best for loans because you only pay interest on the principal amount you borrowed.
What advantage does a personal loan have over credit card debt?
A personal loan can have several advantages over credit card debt. First, personal loans typically have lower interest rates compared to credit cards, which can save you money on interest charges over time. Additionally, personal loans often have a fixed repayment schedule with a fixed interest rate and monthly payments, which can make it easier to budget and plan your payments. This can also help you pay off your debt faster and potentially improve your credit score.
Can I pay my credit card bill with a personal loan?
No, you can't pay your monthly credit card bill directly with a personal loan. You can make credit card payments with a bank transfer or other forms of payment, such as a cashier’s check or money order.
However, you can pay your credit card debt with a personal loan. Some lenders can even use your loan to pay them directly on your behalf. The loan will have a fixed interest rate and a fixed payment amount, making it easier for you to manage your payments.
