Interest is a cost of the use of money. Lenders such as mortgage companies, banks, and credit card companies charge interest to lend money to consumers and businesses. The U.S. government and private businesses borrow money from the general public in the form of bonds they issue and pay interest on. Banks and savings institutions pay interest to depositors for the use of their money. All types of lenders and borrowers charge or pay interest as either "simple" or "compounded."
The difference between simple interest and compound interest is in the way they’re calculated. Simple interest is calculated only on the original principal, while compound interest is calculated on the original principal plus any unpaid interest.
Mortgages and car loans, for example, use simple interest, while savings accounts and certificates of deposits incorporate compound interest.
What’s the Difference Between Simple and Compound Interest?
|Simple Interest||Compound Interest|
|How It Works||Paid on balance only||Unpaid interest added back to balance|
|Debt||Favors borrowers||Favors lenders|
|Deposits||Favors banks and credit unions||Favors depositors|
How It Works
Simple interest is calculated only on the balance of the principal. Here’s an example: The principal and interest of a car loan are paid back over a term, such as 36 months. Each month a portion of your payment goes toward the interest due on the balance, and a portion toward the principal. Here’s what the payments look like for a $10,000 36-month car loan at 3%.
Notice how the interest payments shrink as the principal of the loan goes down.
Compound interest, on the other hand, adds unpaid interest back to the balance, so interest is paid on the interest. Let’s look at what happens to a $10,000 three-year certificate of deposit at 3%.
Notice how the certificate of deposit’s interest goes up each year because interest is paid on the interest.
Most types of loans are figured based on simple interest, but there are some exceptions. Homeowners can take out a reverse mortgage, and there are no payments until the home is sold. However, interest is added monthly to the principal and compounds for the life of the loan. Graduated-payment mortgages, and some forms of student loans, offer payments that are initially lower than on comparable level-rate mortgages. The unpaid interest is added back to the principal, and continues to compound.
A simple-interest loan becomes a compound-interest loan any time the interest due isn’t paid.
Credit card loans charge interest daily, but the interest payment is made monthly. The unpaid daily interest is added back to the balance until it is paid at the end of the month. Credit card skip-payment options add the unpaid interest back to the balance and continue to compound until it is paid.
The annual percentage rate (APR) reflects the impact of the daily compounding period on the interest rate. Lenders, including credit card companies, determine this rate and must tell you what the APR is for the financial product you’re considering.
Bonds are a simple-interest loan from you to a government or company. In exchange for the loan, you receive regular interest payments until the original principal is returned to you at the end of the term.
Savings institution deposits are usually compound interest. But the number of compound periods can make a significant difference. Interest that is paid monthly will accumulate faster than interest paid quarterly.
The annual percentage yield, or APY, reflects the impact of the compounding periods on an interest rate.
What It Means to Investors
Compounding can have a dramatic impact on investment results, both positive and negative. You can use the rule of 72 to see how small changes in interest rates can make a big difference. If you divide 72 by an interest rate, the result is the number of years it takes for your money to double. At 3% interest, for instance, it takes 24 years. At 3.5% it takes 20.5 years.
Compounding is also why negative amortization loans like graduated-payment and reverse mortgages and some types of student loans can be financially crippling. Using the rule of 72, a $100,000 reverse mortgage at 4% becomes a $200,000 mortgage in 18 years.
The Bottom Line
The difference between simple interest and compound interest lies in when the interest is paid. If interest is paid when charged, it is simple. If interest accrues and is added to the balance, then it is compound. Interest that is due daily, monthly, or quarterly is better for depositors and lenders. Interest due annually is more advantageous for borrowers and savings institutions.