Simple vs. Compound Interest: How to Tell the Difference

Simple interest is calculated based only on the principal balance, whereas compound interest is calculated based on the principal balance and the accumulated interest from the previous periods. This means compound interest will make the amount owed grow at a much faster rate than simple interest.

One of the first things you learn when it comes to money management is the concept of interest, which comes into play when you’re lending or borrowing money. Lenders earn interest on the money they lend, while the borrowers pay interest on the money they borrow. Interest is a percentage of the money you borrow or lend that is paid periodically. Although it’s typically quoted on a yearly basis, interest can last for as long or as short a time as the lender requires.

It’s important for borrowers to note that when they pay back the money they borrowed, they typically pay interest. For example, think of a credit card with an annual percentage rate (APR) of 1 percent; when you pay off your bill, you pay the amount you owe in addition to the 1 percent interest. This means you end up paying more than you borrowed.

However, it’s important to remember that interest is typically introduced as simple interest when there are actually two types of interest: simple vs. compound interest. Compound interest is when the amount of interest you pay increases in an upward curve, similar to a snowball effect. Keep reading to learn about the difference between the two and how they apply to your finances.

What Is Simple Interest?

Interest is a fee you pay on top of the money you borrowed when you pay it back, and simple interest is the most basic type of interest you pay. The rate of simple interest doesn’t increase over time so you’ll always know how much you’ll pay.

For example, if you have a credit card with 5 percent APR on which you bought $1,000 worth of purchases, you would ultimately pay back the $1,000 borrowed from the credit card company in addition to 5 percent interest on $1,000 — paying off your entire balance including the simple interest would cost $1,050. Keep reading to learn how to calculate simple interest.

How to Calculate Simple Interest

Similar to the scenario above, calculating simple interest involves three elements: the principal balance, interest rate, and term of the loan. The principal balance is the amount of money borrowed or lent, the interest rate is the additional fee and the term of the loan is how long the money is borrowed or lent before repayment. Check out the simple interest formula below.

Simple interest = principal balance x interest rate x term of the loan

 

What Is Compound Interest?

Compound interest is a fee on a loan or deposit that accounts for the principal balance in addition to the interest accumulated from previous periods.

You may hear compound interest referred to as paying interest on interest. Another factor that influences the interest rate is the frequency of compounding. In other words, the greater the number of compounding periods, the greater the interest rate will be.

How to Calculate Compound Interest

Calculating compound interest involves multiplying the principal balance by one, and then adding the annual interest rate raised to the number of compounding periods minus one. Consequently, the total principal balance is subtracted from the value of the compound interest equation. Find the compound interest formula below.

To easily calculate compound interest, check out our compound interest calculator.

Difference Between Simple and Compound Interest

What differentiates simple versus compound interest is that the latter will make the amount owed grow at a much faster rate than simple interest. This is because simple interest is calculated based only on the principal balance, whereas compound interest is calculated based on the principal balance and the accumulated interest from the previous periods.

Compounding periods are the key element that differentiates simple and compound interest. This is why there is a significant difference in how much interest accrues in instances of compound interest. The greater the number of compounding periods, the greater the amount of compound interest owed.

Real Life Applications

Here’s where we apply what we’ve learned to your finances. Simple interest is typically used when obtaining credit card loans, car loans, student loans, consumer loans, and sometimes even mortgages.

On the other hand, compound interest is often used to boost investment returns in the long term, like 401(k)s and other investments. Another common use of compounding interest is in bank accounts, particularly savings accounts. Student loans, mortgages, and credit cards can also use compound interest so be sure to keep an eye out for the interest rate when making big financial decisions like these. There are no hard and fast rules for what purchases constitute simple or compound interest, so be sure to ask your lender or do your research before borrowing money.

Understanding simple and compound interest is valuable in helping you take control of your finances. Whenever you’re borrowing money, it’s highly likely that interest rates are involved. This makes it even more important to understand the ins and outs of interest and how to maximize your money management. Whether you’re looking to take out a car loan, pick the best credit card, or simply looking to better understand how interest rates work, you’re already off to a great start!

Sources: Investopedia