How to compare simple and compound interest

Anyone who takes out a loan has to think about the cost of doing so. If you need to borrow money to finance a home purchase or a renovation, you’ll want your interest rate to be as low as possible. From an investors’ standpoint, however, higher interest rates present the opportunity to earn higher rates of return. Interest can be simple or it can compound over time. Don’t understand the difference between simple and compound interest? We’ll define both concepts and give plenty of examples.

Do you have questions about how to optimize your finances? Speak to a financial advisor today.

What Is Simple Interest?

The term interest indicates how much you can earn from the money you originally invest. As your investment sits in an account over time, interest accumulates and you can watch your funds grow.

To calculate the amount of simple interest you stand to earn as an investor, you can use the following formula: Principal Balance x Interest Rate. You can then multiply the product by the number of years you’re investing your money to find out what your return rate would look like over time.

For example, if you decide to invest $2,000 in a money market account with a simple interest rate of 8.5%, you’ll earn $170 in interest after one year ($2,000 x 0.085). After five years, you’ll earn $850 (170 x 5) in interest.

What Is Compound Interest? 

Compound interest represents the amount you earn from your initial investment in addition to the interest you earn  – on top of the interest that has already accrued. You can calculate compound interest using the formula, A=P(1+r/n)nt. A is the amount you have after compounding. The value P is the principal balance. The value r is the interest rate (expressed as a decimal), n is the number of times that interest compounds per year and t is the number of years.

Interest can compound either frequently (daily or monthly) or infrequently (quarterly, once a year or biannually). The more often your interest compounds, the more interest you’ll earn on your investment.

It’s easy to see that money grows more quickly when it’s earning compound interest than when it’s earning simple interest. To return to the example above, if you invest $2,000 at an interest rate of 8.5% compounding twice a year for 5 years, your end balance will be $3,032.43. You will have earned $1,032.43 in interest, compared to $850 in the simple interest example.

But if that same investment compounds monthly (12 times a year) instead of twice a year, you’ll end up with a balance of $3,054.60. As you can see, the frequency of compounding makes a difference in terms of your overall return rate. If you want to take advantage of compound interest, it’s a good idea to find out how often your interest will compound before you invest your money.

Simple Interest vs. Compound Interest: What’s the Difference?

Compared to compound interest, simple interest is easier to calculate and easier to understand. If you have a temporary loan or one with interest that doesn’t compound, you’ll only have to worry about interest added onto the outstanding principal balance. With mortgages and most car loans, for example, simple interest accrues but does not compound.

When it comes to investing, compound interest is better since it allows funds to grow at a faster rate than they would in an account with a simple interest rate. Compound interest comes into play when you’re calculating the annual percentage yield. That’s the annual rate of return or the annual cost of borrowing money.

If borrowers can pay off their interest in a shorter period of time, they can then begin paying off their principal loan balance. They’ll be able to pay off their debt more quickly if they’re paying more interest up front.

At the same, if a borrower has a loan that compounds often at a high interest rate, they’ll have higher monthly payments that might not be affordable. In that situation, a borrower might need to consider refinancing the loan to try to get a lower interest rate. For instance, if you’re in the process of paying off your private student loans, you can reach out to a lender to see if you can qualify for a reduced rate.

Bottom Line

Understanding the difference between simple and compound interest is crucial when you’re trying to pick the the right loan or find the best place to store your savings. If you’re a borrower who doesn’t want to get stuck with expensive debt that takes years to eliminate, you’ll probably want a loan with interest that doesn’t compound. But if you’re an investor looking to earn lots of money that you can use in retirement, it’s best to search for an account with interest that compounds frequently.

Financial Planning Tips

• Building and maintaining a financial plan can have major beneficial effects on your future financial life. A financial advisor can help you put together a financial plan. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• You can also try building your own financial plan. To start, check out SmartAsset’s guide to building a family financial plan.

Photo credit: ©iStock.com/solidcolours, ©iStock.com/TwilightEye, ©iStock.com/MachineHeadz

Page 2

Do you know enough about financial management to take care of all of your investing on your own? Or do you need help from a seasoned expert?

That question comes up for millions of Americans each year.

If any of these describe you, you could benefit from professional financial advice:

1. You’re retiring soon – Maximizing retirement income requires smart decisions around complex topics such as Social Security, 401(k) and IRA withdrawals.

2. You manage your own investments – Individual investors should check their strategies with unbiased third parties. You may be overlooking opportunities in your portfolio.

3. You have children – Whether you’re saving for college or planning their inheritance, there are several ways to ensure your children are taken care of.

4. You inherited money – Have you noticed lottery winners often declare bankruptcy? It can be difficult to manage sudden increases in wealth.

5. You have a financial advisor – Depending on how you chose your advisor, there may be a better one for you. Family referrals are convenient but don’t always produce results.

6. You’re divorcing – Untangling finances in a divorce can be messy. Impartial advice is key.

7. You want to build wealth – If you’re still decades from retirement, good decisions today can add thousands to your retirement accounts.

See Your 3 Financial Advisor Matches

Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. Each advisor has been pre-screened and vetted by SmartAsset and is held to a fiduciary standard. If you’re ready to be matched with local advisors that can help you achieve your financial goals, get started now.

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