Simple vs. compound interest: what’s the difference?

A dollar might not change your life. But a dollar a day might. And if that dollar grows bigger every day, it could make or break your finances. The difference between simple interest vs compound interest comes down to how your balance grows over time.

Compound interest makes the numbers grow more quickly than simple interest (like you'd get with a personal loan). If those numbers represent your savings, great. Compounding is what you want. If we're talking about debt, not so great. Compound interest will cost you more.

This stuff can make our brains hurt, so we asked finance expert and published author Mitchell Weiss to help us break it down. Mitchell helps non-finance people understand finance.

Simple interest vs. compound interest

Interest is the cost of using someone else's money. If you use your credit card issuer's money, you pay interest. If you put money in the bank, it pays you interest.

In a nutshell:

When you're borrowing, simple interest generally works in your favor because interest is calculated only on what you owe. When you're saving, compound interest is better because you earn interest on your growing balance.

We'll show you some examples using a $10,000 balance and 12% interest. Typical savings accounts don't earn this much, and typical credit cards cost a lot more. But comparing apples to apples will make it easier to recognize how the types of interest affect your personal finances and which kinds of debt could be more likely to lead to financial hardship.

Simple interest

The least expensive type of consumer loan is one that charges simple interest. Here are some of the most common types of simple interest loans:

• Auto loans

• Mortgages

• Private education loans

• Personal loans

• Boat loans

• RV loans

• Motorcycle loans

Here's how simple interest works, both in terms of borrowing and saving. The first thing you need to know is that simple interest depends on these three factors when you borrow money:

• The amount of money you borrow

• The interest rate you agree to pay

• How long it takes you to pay the loan off in full

The calculation is:

Principal x Interest Rate/12 = Simple Interest Paid per Month

A monthly interest rate is a fraction of your annual rate. For example, a 1% monthly rate works out to about 12% per year (1% x 12 months). If you borrow $10,000 at 1% monthly interest, you'd pay $100 in interest for the first month ($10,000 x 0.01 = $100).

We'll show you some examples that we've simplified for illustration purposes.

Simple interest borrowing example: Personal loan

Let's say Alex borrows $10,000 and agrees to pay 12% interest. Alex's loan term (the amount of time he has to pay the loan off) is three years.

• Each month, 1% interest is added to the amount he borrowed (12% ÷ 12 months = 1%).

• At the end of the first month, Alex owes $10,100 ($10,000 + $100 interest = $10,100).

• Alex makes a monthly payment of $300.

• Alex's balance is now $9,800 ($10,100 - $300 = $9,800).

• The following month, the interest added to Alex's balance is only $98.

• As Alex's balance goes down each month, so do the monthly interest charges.

Later, when we show you how compound interest works, you'll notice that Alex saved money by taking out a loan that uses simple interest.

Simple interest savings example: Certificate of deposit

Certificates of deposit, or CDs, are an unusual type of savings account in that they pay simple interest. Most other savings accounts pay compound interest. Here's a breakdown of what happens when Alex opens a CD:

• Alex puts $10,000 in a one-year CD that pays 12% interest

• To earn 12%, Alex cannot withdraw the money from the CD for the entire year.

• One year later, the CD is considered "mature," and Alex has earned $1,200 in interest ($10,000 x 0.12 = $1,200).

Alex now has $11,200.

Compound interest

Compound interest is great when you're saving money. First, you earn interest, which increases your balance. Then you earn interest on the bigger balance. You're earning interest on interest.

Compound interest is not so great for debts because you'll pay more interest over time. In that case, it's the lender who earns interest on interest.

How often interest compounds matters too. The more frequently interest compounds (daily, monthly, or yearly), the faster a balance grows. A debt that compounds interest daily will cost you more than one that compounds monthly or yearly at the same rate.

Compound interest borrowing example: Credit card debt

Let's say Alex needs to repair a leaky basement but doesn't have the cash. Instead, he charges $10,000 to his credit card.

• Alex charges the $10,000 repair bill on a credit card.

• Like most credit cards, Alex's card compounds daily.

• By the end of the month, an additional $102.42 is added to his total balance.

• Alex makes a payment of $300.

• His balance is now $9,802.42 ($10,102.42 - $300 = $9,802.42).

Compared to our simple interest loan example above, it'll cost Alex an additional $2.42 for the same loan with compound interest. If most or all of your borrowing is at interest rates that compound, your debts will be more expensive overall.

The fact that so many people with credit card debt find themselves trapped in a cycle of paying interest on interest helps explain why so many turn to fixed-rate debt consolidation loans. It's one of the most direct ways to escape the cycle.

Compound interest savings example: Savings account

Compound interest is at its best when it's helping you grow your money. Here's an example of how compound interest works when you save. Again, we'll turn to Alex.

Alex invests $10,000 and earns 12% interest compounded monthly (the bank calculates interest once a month). At the end of one year, Alex has $11,268.25.

Compared to the $11,200 that Alex earned in the simple interest savings example above, compounding has put Alex more than $68 ahead.

The beauty of compounding is that you earn interest on the higher balance every time interest is added. This is why financial planning experts recommend that you start saving early and leave your money alone so it can grow.

Fun fact: The Rule of 72

You can figure out when your money will double by using the Rule of 72. You just need to know the interest rate. This rule only works for annual compounding.

Here's how it works:

• Our friend Alex invests $10,000 and is promised a 5% average rate of return.

• Curious about the investment's expected worth in the future, Alex divides 72 by 5 and gets 14.4.

• If the rate of return doesn't change, Alex's $10,000 will have grown to $20,000 in about 14 years, 3 months.

You can do it, too. Simply divide 72 by the expected rate of return on investment, and you'll have a good idea of how long it will take for your money to double.

The right type of interest for you depends on your financial goals. Be sure to take this into account when comparing loans and savings accounts. If you are struggling with compound interest on your debts, a simple interest personal loan could help. Find out if you qualify.