Compound vs Simple Interest: What’s the Difference and When It Matters

Choosing between products is easier when you know the growth math. Simple interest grows linearly; compound interest accelerates because returns earn returns.

Simple Interest (Linear Growth)

• Interest is calculated only on the original principal
• Each period’s interest is the same dollar amount
• Common in short‑term loans, some promotional offers

Compound Interest (Accelerating Growth)

• Interest is calculated on principal plus previously earned interest
• Each period’s interest is based on a larger balance
• Common in investment accounts, savings, and many loans

Quick Example with Formulas

• Principal: $5,000; Rate: 6% APR; Time: 5 years
• Simple interest: interest = P × r × t = 5,000 × 0.06 × 5 = $1,500 → ending = $6,500
• Compound interest (annual): ending = P × (1 + r)^t = 5,000 × 1.06^5 ≈ $6,691 → interest ≈ $1,691

When It Matters

• Long time horizons: Compounding outperforms simple interest by a wide margin
• Short time horizons: Differences may be modest
• Borrowing: Compounding can increase the total paid if balances aren’t reduced

Choosing Between Products

• For saving/investing, compounding boosts long‑term outcomes
• For debt, aim to minimize compounding by paying down principal faster

FAQs

Which is better for investing? Compound interest. It rewards time in the market and consistent contributions.

Which is better when borrowing? Simple interest. If a loan truly charges simple interest, it’s usually cheaper—confirm terms before borrowing.

Compare scenarios in /finance/compound-interest-calculator and pick products with transparent disclosures (rate, fees, frequency).