Simple or compound interest
The difference between simple interest and compound interest is how interest accrues. Simple interest accrues only on the principal balance, while compound interest accrues on both the principal balance and accrued interest.
Simple interest works in your favor when borrowing money, while compound interest is better for you as an investor. As a borrower, simple interest is preferable because you don’t pay interest on interest. It is easier to pay off a debt with simple interest. Compound interest can help you build wealth over time because your earnings also earn money.
What is simple interest?
Simple interest is calculated, quite simply, on an annual basis as a percentage of the principal amount. You can calculate simple interest by multiplying the principal amount by the annual interest rate and the number of years you are investing or borrowing money for.
Simple interest is usually due on traditional mortgages, car loans and personal loans. Earning simple interest as an investor is relatively rare, although investing in bonds entitles you to earn simple interest for as long as you own the security.
If you borrow $1,000 and pay 7% simple interest for five years, you will pay a total of $350 in simple interest on the debt. If you invest $10,000 in a bond that pays a 5% coupon, you will receive $500 annually until the bond reaches maturity.
What is compound interest?
When you deposit money into an interest-bearing account or draw down a line of credit, the interest that accrues is added to the principal. Interest paid or due is calculated on the basis of capital and accrued interest. Interest can be compounded using any time frame.
Interest on credit card balances is generally compounded daily. If your annual interest rate is 18%, you pay a daily interest rate of 0.0493%. Suppose you have a balance of $5,000. After one day, you owed $5,002.47. The next day, you owed $5,004.94. Compound interest charges can add up quickly when you’re a borrower, but you can avoid accumulating interest on a credit card if you pay off the balance in full each month.
Compound interest helps you earn more money when you save money in an interest-bearing account. Some common types of accounts that pay compound interest include savings accounts, money market accounts, and certificates of deposit (CDs).
In particular, investors can benefit from the power of compounding. By reinvesting earnings and dividend payouts from your portfolio, your money can multiply dramatically over time.
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Simple Interest vs Compound Interest
Simple interest is preferred by borrowers and rarely paid out to investors. Compound interest is a boon for investors and a significant financial burden for people in debt. Simple interest is calculated annually on the principal balance at the start of the period, while compound interest can be accrued at any time interval.
Focusing on savings and investments, simple interest is more common for different types of accounts or securities than compound interest, and vice versa. Here are some examples that illustrate when simple or compound interest is accrued and how interest accrues differently:
- Certificate of deposit: A $1,000 five-year CD earns 4% simple interest. During the term of the deposit, you will receive $200. If the interest paid by the CD were compounded monthly, you would earn a total of $221 instead.
- Reinvestment of dividends: Suppose you buy 100 shares of XYZ Company and the company pays a dividend of $2 per share. You could automatically reinvest the $200 received in dividends, under a dividend reinvestment plan, to buy more shares of the company. Over time, owning more stocks would increase your dividend payouts, allowing you to buy more and more stocks.
- Long term investment: Investing $500 a month for 30 years and earning a 10% annual stock market return adds up to a portfolio worth over $1.1 million. The total investment over 30 years is only $180,000.
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While investors only accept simple interest from savings accounts, generating compound income is necessary to build enough wealth for retirement. Avoid owing compound interest on debt in favor of simple interest debt like mortgages. Focus on investments like stocks that allow your gains to accumulate over time.
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