The difference between simple interest and compound interest is the way the interest accumulates. Simple interest accumulates only on the principal balance, while compound interest accrues to both the principal balance and the accumulated interest.
Simple interest works in your favor when you borrow money, while compound interest is better for you as an investor. As a borrower, simple interest is better because you're not paying interest on interest. It's easier to repay debt with simple interest. Compound interest can help you to build wealth over time because your earnings also earn money.
What is simple interest?
Simple interest is calculated, rather simply, on an annual basis as a percentage of the principal amount. You can compute simple interest by multiplying the principal amount by the annual interest rate and by the number of years for which you invest or borrow money.
Simple interest is usually owed on traditional mortgages, car loans, and personal loans. Receiving simple interest as an investor is relatively rare, although investing in bonds entitles you to earn simple interest as long as you own the security.
If you borrow $1,000 and pay a simple interest rate of 7% for five years, then you would pay a total of $350 in simple interest on the debt. If you invest $10,000 in a bond that pays a 5% coupon, then you would annually receive $500 until the bond reaches maturity.
What is compound interest?
When you deposit money into an interest-bearing account, or draw from a line of credit, the interest that accumulates is added to the principal amount. The interest paid or owed is calculated based on both the principal and interest accrued. Interest can be compounded using any time interval.
Interest on credit card balances typically compounds daily. If your annual interest rate is 18%, then you are paying a daily interest rate of 0.0493%. Suppose you carry a $5,000 balance. After one day, you'd owe $5,002.47. The next day, you'd owe $5,004.94. Compound interest expenses can add up quickly when you're a borrower, but you can avoid accruing interest on a credit card if you pay the balance in full each month.
Compound interest helps you to earn more money when you're saving money in an interest-bearing account. Some common types of accounts that pay compound interest include savings accounts, money market accounts, and certificates of deposit (CDs).
Investors can especially benefit from the power of compounding. By reinvesting your portfolio's gains and dividend payments, your money can multiply significantly over time.
Simple interest vs. compound interest
Simple interest is preferred by borrowers and rarely paid to investors. Compound interest is a boon for investors and a significant financial burden for those in debt. Simple interest is computed annually on the principal balance at the start of the period, while compound interest can be accrued at any time interval.
Focusing on savings and investments, simple interest is more common for different types of accounts or securities than compound interest, and vice versa. Here are some examples that illustrate when simple or compound interest is accrued and how the interest accrues differently:
- Certificate of deposit: A $1,000 five-year CD pays simple interest of 4%. Over the term of deposit, you would receive $200. If the interest paid by the CD compounded monthly, you'd earn a total of $221 instead.
- Dividend reinvestment: Suppose you buy 100 shares of Company XYZ's stock, and the company pays a dividend of $2 per share. You could automatically reinvest the $200 received in dividends, through a dividend reinvestment plan, to buy more of the company's shares. Over time, owning more shares would compound your dividend payments, which would enable you to buy increasingly more shares.
- Buy-and-hold investing: Investing $500 monthly for 30 years and earning a 10% annual stock market return compounds to a portfolio worth more than $1.1 million. The total investment across the 30 years is just $180,000.
While investors accept only simple interest from savings accounts, generating compound earnings is necessary to build enough wealth to retire. Avoid owing compound interest on debt in favor of debts with simple interest such as mortgages. Prioritize investments like stocks that enable your gains to compound over time.