Simple vs. Compound Interest: Key Differences
Simple interest and compound interest are calculated differently, and the difference grows enormous over time. Knowing which type applies to a given loan or savings account can change your financial decisions significantly.
Simple interest: the formula
Simple interest is calculated only on the original principal, never on accumulated interest. Formula: I = P × r × t, where P is the principal, r is the annual rate, and t is the number of years. A $10,000 loan at 5% simple interest for 3 years accrues $1,500 in interest total — the same amount each year.
Compound interest: the formula
Compound interest is calculated on the growing balance, including previously earned interest. The same $10,000 at 5% compounded annually for 3 years grows to $11,576.25 — $76.25 more than simple interest. The gap widens rapidly at higher rates or over longer periods.
When each applies to you
Simple interest is common in short-term personal loans and car loans. Compound interest applies to most savings accounts, investment accounts, mortgages, and credit cards. As a borrower, simple interest is cheaper. As a saver or investor, compound interest makes your money grow faster.