Differences between Compound Interest and Simple Interest
Contents
Compound Interest vs. Simple Interest
Interest is the cost of borrowing money, or the return earned on an investment. The two primary methods for calculating interest are simple interest and compound interest. The fundamental difference lies in how the interest is calculated over time. Simple interest is calculated on the original principal amount, while compound interest is calculated on the principal and the accumulated interest from previous periods.[1][2][3]
Comparison Table
| Category | Simple Interest | Compound Interest |
|---|---|---|
| Calculation Basis | Calculated only on the initial principal amount.[1][4][5][2] | Calculated on the principal amount plus any interest that has already accrued.[1] |
| Growth Pattern | Linear. The interest earned each period is constant. | Exponential. The interest earned increases with each period as the principal balance grows. |
| Formula | A = P(1 + rt) where A is the total accrued amount, P is the principal, r is the interest rate, and t is the time. | A = P(1 + r/n)^(nt) where A is the future value of the investment/loan, P is the principal, r is the annual interest rate, n is the number of times that interest is compounded per year, and t is the number of years. |
| Interest Earned | Less interest is generated over time compared to compound interest.[5] | Generates a higher amount of interest over the same period, assuming the same principal and interest rate. |
| Common Applications | Often used for shorter-term loans such as auto loans and some personal loans. | Used for long-term investments, savings accounts, credit cards, and some mortgages. |
Simple Interest
Simple interest is a straightforward method for calculating the interest charge on a loan or investment. It is determined by multiplying the principal amount by the interest rate and the duration of the loan or investment.[1] For example, a $1,000 loan with a 5% annual simple interest rate will accrue $50 in interest each year. After three years, the total interest would be $150. This method results in a constant, predictable amount of interest over the life of the loan.
Compound Interest
Compound interest, often referred to as "interest on interest," is calculated on the initial principal and the accumulated interest from previous periods.[1] This means that interest payments grow over time, leading to exponential growth of the principal amount. For instance, a $1,000 investment with a 5% annual compound interest rate would earn $50 in the first year. In the second year, the interest would be calculated on the new principal of $1,050, resulting in $52.50 of interest. The frequency of compounding, whether daily, monthly, or annually, can significantly affect the total amount of interest accrued.
Key Implications for Borrowers and Investors
For borrowers, loans with simple interest are generally less expensive over the long term because the interest is not added to the principal balance.[1] Conversely, for investors, compound interest is more advantageous as it allows investments to grow at a faster rate. The longer the investment period, the more significant the effect of compounding becomes, making it a powerful tool for long-term wealth accumulation.
References
- ↑ 1.0 1.1 1.2 1.3 1.4 1.5 "investopedia.com". Retrieved January 23, 2026.
- ↑ 2.0 2.1 "capitalone.com". Retrieved January 23, 2026.
- ↑ "fidelity.com". Retrieved January 23, 2026.
- ↑ "cuemath.com". Retrieved January 23, 2026.
- ↑ 5.0 5.1 "bank.in". Retrieved January 23, 2026.
