What is Simple vs Compound Interest?
Understanding the difference between simple and compound interest is crucial for making smart financial decisions. While both calculate interest on your money, they work very differently and can result in significantly different returns over time.
Simple Interest
Simple interest is calculated only on the original principal amount. The interest earned each period remains constant because it's always based on the initial investment, not on accumulated interest.
Simple Interest = Principal × Rate × Time
SI = P × r × t
Compound Interest
Compound interest is calculated on both the initial principal and the accumulated interest from previous periods. This means you earn "interest on interest," which causes your money to grow exponentially over time.
Final Amount = Principal × (1 + Rate/n)^(n×Time)
A = P(1 + r/n)^(nt), where n = compounding frequency per year
Key Differences
Simple Interest
Interest calculated only on principal
Linear growth over time
Same interest amount each period
Common in short-term loans
Compound Interest
Interest calculated on principal + accumulated interest
Exponential growth over time
Interest increases each period
Common in savings accounts, investments
When Each Type is Used
Simple Interest Applications:
- Auto loans and personal loans
- Short-term certificates of deposit
- Some bonds and fixed deposits
Compound Interest Applications:
- Savings accounts and money market accounts
- Investment accounts and retirement funds
- Credit cards and mortgages (as a borrower)
The Power of Compounding
Albert Einstein reportedly called compound interest the "eighth wonder of the world." The longer your money compounds, the greater the difference becomes. A 10-year investment at 8% will show a modest advantage for compound interest, but over 30 years, the difference becomes dramatic.