Simple vs. compound interest: what’s the difference?

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 CDs pay a specific amount in interest on a set date, and the money can't be withdrawn until that date.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.