Compound Interest vs. Simple Interest Differences and Similarities

by Beth Winston

If you invest it correctly, your money should make more money. Earning interest can be a powerful wealth-building tool, so long as time is on your side. Learn about the different types of interest-earning mechanisms to maximize your returns, because simple and compound interest are very different.

Simple Interest

Simple interest is just that. It is interest earned at a given rate on an investment. For instance, if you invested $200 in an account that gave you a 5 percent return, at the end of one year, you would own $210.

Compound Interest

Compound interest is, in essence, interest that is added to the principal, earning interest on the full amount. The more often the interest is added, the more you earn. If you invest your $200 in an account that pays compound interest at 5 percent, compounding (adding interest) monthly, at the end of one year you would own $210.23. If instead of compounding monthly, the account compounded daily, at the end of one year you would own $210.25

Similarities

Both simple and compound interest grow your money. If you keep your account in credit, at the end of the year you will have more money than when you started. Both mechanisms reflect the cost to the bank of borrowing your money. When applied to a loan you have taken out, they reflect the cost to you of borrowing that cash.

Differences

Simple interest is computed only on the principal you have invested or borrowed. Compound interest is computed on the principal, plus whatever interest has already been added. Simple interest is usually used on short-term accounts or loans. Compound interest is usually used on long-term accounts or loans. Compound interest essentially works much faster than simple interest; its growth is exponential, whereas that of simple interest is constant.