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Interest is the cost of borrowing money or the return you earn for saving or investing, usually expressed as a percentage. But interest comes in different forms, so it’s important to understand how charges apply before signing up for any loan or investment.
Interest can be simple or compound, which changes its calculation and how much you can expect to pay or earn. Simple interest is straightforward, applying only to the principal amount you borrow or deposit, while compound interest applies to both the principal and the interest that accrues on this amount.
Read on to learn more about simple vs. compound interest and the differences between the two so you can make the best choice among financial products. You’ll also see how compounding frequency affects returns and why APR and APY aren’t the same thing.
Key Insights
- Simple interest applies only to a financial product's principal (the amount you borrow or deposit), while compound interest applies to principal and accrued interest.
- Calculating the amount of interest you'll owe or receive depends on the type of interest associated with the account in question.
- Simple interest is largely preferable when borrowing money since it reduces the amount you'll owe over time, while compound interest benefits investors as it increases the amount you'll earn on those accounts.
- Compound interest can grow at different rates, depending on how often interest compounds (daily, quarterly, or yearly), while simple interest is typically expressed as an annual percentage rate (APR).
What Is Interest?
When you borrow money, you will almost always have to pay a fee in addition to repaying what you borrowed. Interest is the cost of borrowing money (or the return you earn for saving or investing), typically expressed as a percentage.
You’ll find interest on most financial products, whether you are the borrower taking out a loan for a car, home, or personal expense or a lender investing in a certificate of deposit (CD) or high-yield savings account.
However, calculating the interest you owe — or are owed — depends on the type of interest associated with the account, which could be simple or compound.
Types of Interest
At a glance:
- Simple interest: calculated on the principal only.
- Compound interest: calculated on principal + accumulated interest.
- Borrowing (often): installment loans/mortgages (interest on outstanding balance).
- Saving/investing (often): savings accounts, CDs, and investment growth.
- Credit cards: interest typically accrues using a daily rate.
Simple Interest
Simple interest is as straightforward as it sounds and much easier to calculate.
“
It’s calculated only on the original amount, called the principal,
– Baruch Mann (Silvermann), financial expert and CEO of The Smart Investor.
That means simple interest is calculated on the principal (or outstanding balance for many loans), not on previously earned interest. Your rate may be fixed or variable, and the payment structure depends on the product, but the math is generally more straightforward than compounding. You most often see simple interest at work with consumer loans (home, auto, personal loans),
– Patrick Sabol, certified financial planner (CFP) and senior lead planner at Facet.
Simple interest is common with these types of loans because it results in straightforward monthly payments that the borrower can easily plan for.
Simple Interest Formula
To calculate simple interest, you’ll need to know your principal amount, annual interest rate, and loan term.
“
Simple interest is calculated annually based on the principal balance only. The formula for simple interest is I = P*r*t. In the formula, P is the total principal, r is the interest rate, and t is the term.
– Laura Sterling, vice president of marketing at Georgia's Own Credit Union.
Simple Interest Example
“If you borrow $20,000 at 4% simple interest for 5 years and don’t make payments until the end of the term (a simplified example), the interest would be:
$20,000 × 0.04 × 5 = $4,000
In many real-world auto loans, you make monthly payments and the principal declines over time, so total interest depends on the payment schedule.
Compound Interest
Compound interest is a bit more complicated than simple interest, as it builds on itself (compounds).
“Compound interest is interest on both the principal and the interest that’s already been added,” says Mann.
Because compound interest grows over time, it is more common with investment products — allowing investors to yield higher returns — and less common on loans.
“You see compound interest at work with fixed-income products such as CDs and bonds (most CDs compound daily or monthly, and bonds generally every six months), which can be a good investment for short-term savings goals or for investors seeking income over growth,” says Sabol. Many bonds pay interest on a set schedule (U.S. Treasurys pay every six months), and whether your returns compound depends on whether you reinvest those payments.
Still, some borrowing options, including credit cards, come with compound interest. Credit cards are a common example of borrowing with compounding behavior, since interest is typically calculated using a daily periodic rate and can effectively accumulate daily.
Compound Interest Formula
Calculating compound interest can be a bit more complicated than simple interest.
“It can be calculated daily, monthly, quarterly, or annually,” said Sterling.
“The formula for compound interest is A = P(1 + r/n)^(nt). In the formula, P is the total principal, r is the interest rate, n is the number of compounding periods per year, and t is the number of years,” she adds.
Compound Interest Example
To calculate compound interest, you’ll need to know your current balance and interest rate, just like with simple interest. But unlike simple interest, compound interest earnings will apply to the interest as well.
“For example, if you invest $10,000 at a 4% compound interest rate, you’ll earn $400 in the first year. But in the second year, you earn interest on $10,400, so you’ll get $416, and it keeps growing,” says Mann.
Simple Interest vs. Compound Interest: Key Differences
The most fundamental difference between simple and compound interest is that simple interest only applies to the principal amount, while compound interest applies to the principal plus interest. Other variances between the two types of interest include:
- Compound interest can grow at different rates. With simple interest, interest is calculated on the principal (or outstanding balance). With compound interest, growth depends on how often interest is compounded (daily, monthly, quarterly, or annually), depending on the product.
- Simple interest is more favorable for borrowers. The straightforward formula and predictable payments associated with simple interest make it the better option for most loans. That is because compounding interest could result in you paying more over time.
- Compound interest is more favorable for lenders. The compounding nature of compound interest yields higher charges — and higher returns for the lender. That makes it the better option for most savings and investment products, especially if you plan to invest over a long period of time.
Simple or Compound Interest: Which Is Better?
Simple interest may be easier to understand, but compound interest often yields higher returns. Most generally, simple interest is more beneficial when you are borrowing money, while compound interest is beneficial when you are lending money, though there may be a few exceptions.
"If you are getting a loan, simple interest loans generally mean you will pay less interest over the life of the loan," Sterling says. "Simple interest loans are also good for borrowers who want a straightforward payment structure. On the flip side, a compound-interest loan could provide a better interest rate and save you less in the long run if you can pay it off quickly. If you are opening a deposit account, you'll generally earn more with compound interest."
Sabol added that while it can take time to see the benefits of compound interest, it is usually worth the long-term investment.
Frequently Asked Questions
1. Is APR the same as APY?
No. APR is the annual interest rate without factoring in compounding, while APY reflects the effect of compounding over a year. APY is most commonly used for savings and investment accounts.
2. Do mortgages use simple interest or compound interest?
Many mortgages use a simple-interest style calculation on the outstanding principal balance, but the way interest accrues and how payments are applied depends on the loan terms. Always review your loan disclosures to see how interest is calculated.
3. Do credit cards charge simple or compound interest?
Credit cards typically calculate interest using a daily periodic rate, so interest can effectively accumulate day by day. Paying your statement balance in full each month helps you avoid interest charges.
4. Which is better for saving: simple or compound interest?
In most cases, compound interest is better for saving because you can earn interest on both your original deposit and the interest you’ve already earned. The benefit is bigger when interest compounds more frequently, and you leave the money invested longer.
Written byEmily Sherman
Emily Sherman is a personal finance expert at BestMoney.com, specializing in online banking. Her work has appeared in U.S. News & World Report, Buy Side from the Wall Street Journal, Newsweek, and more. As a veteran journalist, Emily leverages her expertise to help readers make informed financial decisions.