How Compound and Simple Interest Differ
Simple interest is calculated only on the original principal amount. The formula is I = P x r x t, where P is principal, r is the annual rate, and t is time in years. A $10,000 deposit at 5% simple interest earns exactly $500 every year regardless of how long it is held. The total interest after 10 years is $5,000, and after 20 years is $10,000 — growth is perfectly linear.
Compound interest, by contrast, calculates interest on the principal plus all previously earned interest. The same $10,000 at 5% compounded annually earns $500 in year one but $525 in year two (5% of $10,500), $551.25 in year three, and so on. After 10 years the total interest is $6,289 rather than $5,000, and after 20 years it is $16,533 rather than $10,000. The gap accelerates with each passing year.
This calculator displays both growth curves on the same timeline, making the exponential nature of compound interest visually obvious. It also shows the exact dollar difference at each milestone so you can quantify the compounding advantage. For borrowers, this comparison reveals why compound interest loans cost substantially more than simple interest loans over the same term.
Example: Comparing Both Interest Types
You invest $15,000 at a 6% annual rate for 20 years.
- Simple interest total: $15,000 + ($15,000 x 0.06 x 20) = $15,000 + $18,000 = $33,000.
- Compound interest total (annual): $15,000 x (1.06)^20 = approximately $48,107.
- The compound interest advantage: $48,107 - $33,000 = $15,107 more earned through compounding.
- After 30 years the gap grows further: $42,000 simple vs $86,226 compound — a $44,226 difference.
- This illustrates why compound interest is called the eighth wonder of the world by financial educators.
Tips for Accurate Results
- Always choose compound interest accounts for savings and investments. The compounding advantage grows exponentially and can double your returns over decades.
- When borrowing, simple interest loans are preferable because total interest costs are lower and more predictable than compound interest loans.
- Some auto loans and personal loans use simple interest, which benefits borrowers who make extra payments since the interest does not compound on the remaining balance.
- Understand that advertised APR on compound interest products understates the true annual cost or return. Always look at the APY to see the effective rate after compounding.
Frequently Asked Questions
Which is better for savings: simple or compound interest?
Compound interest is always better for savings because you earn interest on your accumulated interest, creating exponential rather than linear growth. Over 30 years at 5%, compound interest produces 2.7 times more total interest than simple interest on the same principal. Virtually all modern savings accounts and CDs use compound interest, making it the default for consumer savings products.
Do any financial products still use simple interest?
Yes, several common financial products use simple interest. Most auto loans, some personal loans, and Treasury bonds calculate interest on the original principal only. Simple interest is also used for short-term loans, promissory notes, and some student loans during deferment periods. These products are borrower-friendly because the total interest cost is lower and more predictable.
How much more does compound interest earn over 10 years?
The advantage depends on the rate. At 5% over 10 years on $10,000: simple interest earns $5,000 while compound earns $6,289 — a 26% advantage. At 8%, simple earns $8,000 and compound earns $11,589 — a 45% advantage. At 12%, simple earns $12,000 and compound earns $21,058 — a 75% advantage. Higher rates amplify the compounding effect dramatically.
Why do credit cards use compound interest?
Credit card companies use compound interest (specifically, daily compounding) because it maximizes the interest revenue they collect from cardholders who carry balances. At a 22% APR compounded daily, the effective annual rate is about 24.6%. This is why financial advisors emphasize paying off credit card balances in full each month to avoid the compounding penalty.