Simple vs. Compound Interest | The Motley Fool (2024)

The difference between simple interest and compound interest is the way the interest accumulates. Simple interest accumulates only on the principal balance, while compound interest accrues to both the principal balance and the accumulated interest.

Simple interest works in your favor when you borrow money, while compound interest is better for you as an investor. As a borrower, simple interest is better because you're not paying interest on interest. It's easier to repay debt with simple interest. Compound interest can help you to build wealth over time because your earnings also earn money.

What is simple interest?

Simple interest is calculated, rather simply, on an annual basis as a percentage of the principal amount. You can compute simple interest by multiplying the principal amount by the annual interest rate and by the number of years for which you invest or borrow money.

Simple interest is usually owed on traditional mortgages, car loans, and personal loans. Receiving simple interest as an investor is relatively rare, although investing in bonds entitles you to earn simple interest as long as you own the security.

If you borrow $1,000 and pay a simple interest rate of 7% for five years, then you would pay a total of $350 in simple interest on the debt. If you invest $10,000 in a bond that pays a 5% coupon, then you would annually receive $500 until the bond reaches maturity.

What is compound interest?

When you deposit money into an interest-bearing account, or draw from a line of credit, the interest that accumulates is added to the principal amount. The interest paid or owed is calculated based on both the principal and interest accrued. Interest can be compounded using any time interval.

Interest on credit card balances typically compounds daily. If your annual interest rate is 18%, then you are paying a daily interest rate of 0.0493%. Suppose you carry a $5,000 balance. After one day, you'd owe $5,002.47. The next day, you'd owe $5,004.94. Compound interest expenses can add up quickly when you're a borrower, but you can avoid accruing interest on a credit card if you pay the balance in full each month.

Compound interest helps you to earn more money when you're saving money in an interest-bearing account. Some common types of accounts that pay compound interest include savings accounts, money market accounts, and certificates of deposit (CDs).

Investors can especially benefit from the power of compounding. By reinvesting your portfolio's gains and dividend payments, your money can multiply significantly over time.

Simple vs. Compound Interest | The Motley Fool (1)

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Simple interest vs. compound interest

Simple interest is preferred by borrowers and rarely paid to investors. Compound interest is a boon for investors and a significant financial burden for those in debt. Simple interest is computed annually on the principal balance at the start of the period, while compound interest can be accrued at any time interval.

Focusing on savings and investments, simple interest is more common for different types of accounts or securities than compound interest, and vice versa. Here are some examples that illustrate when simple or compound interest is accrued and how the interest accrues differently:

  • Certificate of deposit: A $1,000 five-year CD pays simple interest of 4%. Over the term of deposit, you would receive $200. If the interest paid by the CD compounded monthly, you'd earn a total of $221 instead.
  • Dividend reinvestment: Suppose you buy 100 shares of Company XYZ's stock, and the company pays a dividend of $2 per share. You could automatically reinvest the $200 received in dividends, through a dividend reinvestment plan, to buy more of the company's shares. Over time, owning more shares would compound your dividend payments, which would enable you to buy increasingly more shares.
  • Buy-and-hold investing: Investing $500 monthly for 30 years and earning a 10% annual stock market return compounds to a portfolio worth more than $1.1 million. The total investment across the 30 years is just $180,000.

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While investors accept only simple interest from savings accounts, generating compound earnings is necessary to build enough wealth to retire. Avoid owing compound interest on debt in favor of debts with simple interest such as mortgages. Prioritize investments like stocks that enable your gains to compound over time.

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Simple vs. Compound Interest | The Motley Fool (2024)


Simple vs. Compound Interest | The Motley Fool? ›

Simple interest vs.

Is it better to earn compound or simple interest? ›

It depends on whether you're saving or borrowing. Compound interest is better for you if you're saving money in a bank account or being repaid for a loan. If you're borrowing money, you'll pay less over time with simple interest. Simple interest really is simple to calculate.

Which is more profitable simple interest or compound interest? ›

Compound interest causes your wealth to grow faster. It makes a sum of money grow at a faster rate than simple interest because you will earn returns on the money you invest, as well as on returns at the end of every compounding period. This means that you don't have to put away as much money to reach your goals!

How to tell the difference between simple interest and compound interest? ›

Simple interest is calculated on the principal, or original, amount of a loan. Compound interest is calculated on the principal amount and the accumulated interest of previous periods, and thus can be regarded as “interest on interest.”

Do investors savers prefer compound interest or simple interest Why? ›

Compound interest helps you to earn more money when you're saving money in an interest-bearing account. Some common types of accounts that pay compound interest include savings accounts, money market accounts, and certificates of deposit (CDs). Investors can especially benefit from the power of compounding.

What are the disadvantages of simple interest? ›

Disadvantages of Simple Interest

Ignoring the Time Value of Money: Simple interest does not account for the time value of money, which is the concept that a dollar received or paid today is worth more than the same dollar received or paid in the future due to the opportunity cost of using the money elsewhere.

What are the disadvantages of compound interest? ›

Your interest is calculated not only on the balance owed but also on the interest that has already accrued. This can result in a snowball effect, where your debt grows more quickly, making it harder to pay off.

What is the miracle of compound interest? ›

Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid. Compounding thus can be construed as interest on interest—the effect of which is to magnify returns to interest over time, the so-called “miracle of compounding.”

What is the magic of compound interest? ›

When you invest, your account earns compound interest. This means, not only will you earn money on the principal amount in your account, but you will also earn interest on the accrued interest you've already earned.

Why do you earn more money with compound interest than with simple interest? ›

Why do you earn more money using compound interest than you would using simple interest? because compound interest is on the base amount you invested plus the money you made in interest in previous years. Simple interest is receiving the same percentage only on the base amount you have in your account every year.

Is it better to get interest annually or monthly? ›

However, savings accounts that pay interest annually typically offer more competitive interest rates because of the effect of compounded interest. In simple terms, rather than being paid out monthly, annual interest can accumulate over the year, potentially leading to higher returns on the sum you've invested.

How often is simple interest compounded? ›

Simple interest is calculated on the principal amount only. The interest is paid at regular intervals, such as monthly or annually. For example, if someone invested $100 at a simple interest rate of 5% for five years, they would end up with $125.

Is daily compounding better than monthly? ›

The higher the APY, the better. Compound frequency: The more regularly the interest compounds — say, daily versus monthly — the faster your money will grow. If you add $2,000 to an account earning 2% interest that compounds daily, you would earn $40.40 in interest in one year.

What is a real life example of compound interest? ›

Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns. Let's say you have $1,000 in a savings account that earns 5% in annual interest. In year one, you'd earn $50, giving you a new balance of $1,050.

Do banks use compound or simple interest? ›

Answer and Explanation: Most of the banks use compound interest rate with differing frequency. The banks are, therefore, required to quote effective annual rates so that different rates can be compared by the borrowers. Simple interest compounding is rarely used in the banking sector.

What is the compound interest rate for the S&P 500? ›

Interest rate

The Standard & Poor's 500® (S&P 500®) for the 10 years ending December 31st 2023, had an annual compounded rate of return of 15.2%, including reinvestment of dividends.

Why is compound interest better? ›

This means, not only will you earn money on the principal amount in your account, but you will also earn interest on the accrued interest you've already earned. The idea of compound interest (as compared to simple interest) is fundamental to investing because it can ultimately lead to a greater return in your account.

Is it preferable to earn interest that is compounded? ›

Explanation: Given a choice, it is preferable to have your interest compounded daily. The frequency of compounding interest has a significant impact on the growth of an investment over time. Compound interest behaves in the same way as productivity rates, where small changes can significantly increase income over time.

Is compound interest a good way to make money? ›

The Bottom Line

Compound interest and compounding can supercharge your savings and retirement potential. Successful compounding lets you use less of your own money to reach your goals. However, compounding can also work against you, like when high-interest credit card debt builds on itself over time.

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