Compound versus Simple Interest

I have had people ask me what the difference is between simple and compound interest. Because of the questions, I decided that I will talk about it today.

Simple Interest

Simple interest is interest you earn on your money. If you have $100 in the bank and you earn 10% interest, after one year with simple interest you will have earned $10. In the next year, your bank account, now having $110 still earns 10% interest. At the end of the second year, you earned $10. You now have $120. As you can see, in the second year, you still earn interest on the original $100. When you think of simple interest, remember that your money grows slowly with simple interest.

Compound Interest

Compound interest is interest you earn not only on your money, but on the interest as well. Using the same example from above, with $100 invested at 10%, at the end of the first year, you have earned $10 in interest. You may notice that is the same you earned with simple interest. While this is correct, difference between simple and compound interest has not yet been seen.

At the end of the second year, still earning 10% interest, you earned $11 in interest. Why the extra $1? Because in the second year, with compound interest, you earned interest on the interest you previously earned. Put another way, you earned interest on the $10 you earned last year. With simple interest, you are only earning interest on your principal amount.

Why Compound Interest is The Path to Wealth

You may be thinking that the extra $1 isn’t a big deal. But it is. Take a look at the chart below. It assumes that you invested $100 at 10% (same as above). The first column is the amount of money you have at a given year if you earned simple interest. The second column is the amount of money you have at a given year if you earned compound interest.

As you can see, at the start, there doesn’t appear to be much of a difference. But look what happens after 10 years and beyond. That is huge. Below is the same information as a graph (clicking on it will make it bigger).

If you had to pick which line was your bank account balance, which one would you choose? I’m hoping you picked compound interest!I hope that this post clears up any confusion over simple and compound interest. As an added benefit, I have a compound interest calculator for you to use on my site (as well as many other ones too) for free.

As always, if you have a question, email me!

Tagged as: Investing, Personal Finance Basics, Savings Accounts