Simple vs compound interest, explained

How each one grows, where you will meet them, and why time matters more than how often interest compounds.

Interest is the price of money: what a lender charges you, or what a bank pays you. Simple interest is worked out on the original amount only. Compound interest is worked out on the original amount plus any interest already added. Simple interest Simple interest = principal × yearly rate × years. Deposit $5,000 at 4% simple interest for 3 years and you earn 5,000 × 0.04 × 3 = $600. You earn the same $200 every year, because it is always based on the original $5,000. You will meet simple interest in some car loans, short-term personal loans, and certain bonds. Compound interest Compound balance = principal × (1 + rate ÷ n) ^ (n × years), where n is how many times a year interest is added. The same $5,000 at 4%, compounded once a year, grows to $5,624.32 after 3 years. That is $24.32 more than simple interest, because each year’s interest also earns interest. Savings accounts, certificates of deposit, investments, and credit card balances all compound. Over long periods the gap grows Here is $5,000 at 4% a year, left alone: Does compounding more often matter? Monthly or daily compounding adds a little more than yearly compounding, but the difference is small next to the effect of the…