If you've ever read a loan disclosure or compared savings accounts, you've encountered both simple and compound interest ? often without a clear explanation of how they differ. The terminology sounds almost interchangeable, but the financial outcomes are anything but. Over a decade or more, the gap between them can amount to thousands of dollars.
Simple Interest: The Basics
Simple interest is calculated on the original principal only. No matter how much time passes, the calculation always uses that same starting number.
Where:
I = Interest earned or owed
P = Principal
r = Annual interest rate (decimal)
t = Time in years
Example: $10,000 at 6% simple interest for 5 years earns $10,000 × 0.06 × 5 = $3,000. Every year you earn exactly $600 ? no more, no less. The growth is perfectly linear.
Compound Interest: Interest on Interest
Compound interest calculates interest on the current balance ? which includes all previously earned interest. The balance grows exponentially rather than linearly.
Where:
A = Final amount P = Principal
r = Annual rate n = Compounding periods/year t = Years
Same example at 6% compounded annually for 5 years: $10,000 × (1.06)5 = $13,382. That's $382 more than simple interest ? and the gap accelerates dramatically over time.
Side-by-Side: The Growing Gap
| Year | Simple Interest Balance | Compound Interest Balance | Difference |
|---|---|---|---|
| 1 | $10,600 | $10,600 | $0 |
| 5 | $13,000 | $13,382 | $382 |
| 10 | $16,000 | $17,908 | $1,908 |
| 20 | $22,000 | $32,071 | $10,071 |
| 30 | $28,000 | $57,435 | $29,435 |
By year 30, compound interest produces more than double the balance of simple interest on the same deposit at the same rate.
Where Each Type Appears in Real Life
Products that use simple interest
- Most auto loans ? Interest is calculated on the declining outstanding balance each month.
- Many personal loans ? Installment loans from banks often use simple interest amortization.
- U.S. Treasury Bills ? Short-term government securities use a simple interest discount method.
Products that use compound interest
- Savings accounts and HYSAs ? Compound daily, credited monthly. The APY you see reflects this.
- CDs ? Compounding over the term. Use our CD Rate Calculator to compare.
- Credit cards ? Daily compounding at high APRs makes unpaid balances grow rapidly.
- Mortgages ? Compound interest applied monthly. See the Mortgage Calculator for a full amortization breakdown.
- Investment accounts ? Returns compound as gains generate additional gains.
APR vs. APY: How Lenders Disclose Interest Type
- APR (Annual Percentage Rate) ? Used for loans. The nominal rate, must include fees.
- APY (Annual Percentage Yield) ? Used for deposit accounts. Reflects the true annual return after compounding.
Always compare savings accounts using APY. Our APY/APR Calculator converts between the two instantly.
The Rule of 72: A Compound Interest Shortcut
Divide 72 by the annual interest rate to estimate how many years it takes to double your money. At 6%: 72 ÷ 6 = 12 years. This only works with compound interest ? simple interest has no clean doubling period. See The Rule of 72 Explained for a full walkthrough.
For a deeper look at compound interest specifically, see What Is Compound Interest and Why It's the Most Important Concept in Personal Finance.