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

Accruing interest is one of the best ways to grow your wealth over time, either personally or for your business.

But before you dive into the many different ways to go about earning interest on your investments, it’s crucial to understand what interest is, and how it works.

Interest, which is either the cost of borrowing or reward for saving money, comes in multiple forms: simple and compounding. 

In this guide, we’ll break down both–  and help you figure out which one is right for you. 

What is simple interest? 

Simple interest, put simply, is interest that is calculated based on your initial investment or amount borrowed. The formula goes as follows:

\[ \text{Simple Interest} = \text{Principal} \times \text{Rate} \times \text{Time} \]

Where:

• Principal is the initial sum of money.

• Rate is the percentage of interest per period.

• Time is the duration for which the money is borrowed or invested.

With simple interest, the amount of interest you’re either charged or paid back is always based on the same amount: the principal. So, it is calculated based on however much you have either invested or borrowed during a given period. It does not account for interest on previously accrued or borrowed interest. 

How does it work?

Let’s say you invest $1,000 at an annual interest rate of 5% for 3 years. Using simple interest, you'll earn:

\[ \$1,000 \times 0.05 \times 3 = \$150 \]

That means after 3 years, your total balance will be $1,150.

There are a few instances in which simple interest is used. Some CDs, or certificates of deposit, use simple interest, where you agree to a set amount of interest on your investment over a period of time. This route makes sense for a short term investment to accrue some interest as opposed to none at all. 

On the other hand, auto loans are typically calculated using a simple interest rate. Each month, your payment goes in part to the principal, and in part to the interest. As the principal goes down, less of your payment ends up needing to go toward the principal each month. 

What is compound interest?

Compound interest is interest that is calculated not only on your principal investment or amount borrowed, but on all principal and interest accumulated from the previous periods. This makes compound interest a more appealing option for long-term financial growth, and more dangerous for accruing debt.  The formula goes as follows: 

\[ \text{Compound Interest} = \text{Principal} \times (1 + \text{Rate})^{\text{Time}} - \text{Principal} \]

This method effectively earns you "interest on interest," which can significantly increase your returns over time.

How does it work? 

We can take the same example from earlier to determine how compound interest works. Compound interest can accrue daily, monthly or annually. For this example, let’s say your interest compounds annually. 

The same $1,000 investment at a 5% interest rate for 3 years would grow as follows:

• Year 1: \( \$1,000 \times 1.05 = \$1,050 \)

• Year 2: \( \$1,050 \times 1.05 = \$1,102.50 \)

• Year 3: \( \$1,102.50 \times 1.05 = \$1,157.63 \)

While in the short-term, the difference is not that big (you’ll earn just $7.63 more with compound interest in this example after three years), the longer your money grows, the more 

In this scenario, you'd have $1,157.63, which is $7.63 more than with simple interest. Over longer periods, as the amount you’re accruing interest on grows even bigger, this difference becomes even more pronounced, making compound interest a powerful tool for building wealth.

How can I use compounding interest to my advantage?

While simple interest is definitely an effective way to earn money on a short term basis, compounding interest can lead to significant financial growth over time. That’s why it’s important to know best how to use it. No matter how minimal or large the amount of money you have available to invest is, there are a few ways to make the most of your money with compounding interest.

1. Start early. This one is kind of a no brainer, and there is no bad time to start investing. But the sooner your start, the more time you give your money to compound, allowing it to grow way more in the long run.

2. Invest regularly. Even if you only have a small amount to invest each month, consistent contributions make the total amount of money interest is calculated on grow, which will lead to, you guessed it, more money!

3.  Reinvest your earnings. Keeping your earnings in your investment account, as opposed to withdrawing them, helps your balance grow faster. 

The bottom line 

Depending on your financial situation and goals, both simple and compounding interest are fine options when it comes to investing. Simple interest provides straightforward calculations, while compound interest offers bigger growth over time.

For young investors and small business owners, leveraging compound interest can mean the difference between meeting financial goals and surpassing them. Whether you're saving for retirement or managing a business loan, knowing how to use interest to your advantage is a vital skill.

Take the next steps in your financial literacy journey by exploring more resources from Stash, or speaking with a financial advisor to tailor strategies to your specific needs. With the right knowledge and tools, you can confidently move forward on your path to financial success.