Simple Interest vs Compound Interest: What's the Difference?
Simple interest and compound interest produce very different outcomes over time. Learn how each works, with formulas, examples, and why compound interest is called the eighth wonder of the world.
Simple interest is calculated only on the original principal. Compound interest is calculated on the principal plus any previously earned interest. The difference seems small over a short period but becomes enormous over decades, and it works for or against you depending on whether you are saving or borrowing.
Simple Interest vs Compound Interest: The Definitions
Simple interest is calculated only on the original principal amount. The interest earned each period is always the same, it does not grow over time.
Formula
Simple Interest = Principal × Rate × Time. Final Amount = Principal × (1 + Rate × Time)
Example
£10,000 at 5% simple interest for 10 years. Interest = £10,000 × 0.05 × 10 = £5,000. Final amount = £15,000.
Compound interest is calculated on the principal plus any accumulated interest. Each period, your interest earns interest. The more frequently interest compounds, the faster the growth.
Formula
A = P(1 + r/n)^(nt). Where P = principal, r = annual rate, n = compounding periods per year, t = years
Example
£10,000 at 5% compound interest annually for 10 years. A = £10,000 × (1.05)^10 = £16,289. That's £1,289 more than simple interest over the same period.
Key Differences
- 1Simple interest is linear; compound interest is exponential
- 2Over 10 years at 5%, compound interest produces £1,289 more than simple interest on a £10,000 investment
- 3Over 30 years at 5%, compound interest produces £43,219 vs £15,000 for simple interest on a £10,000 investment
- 4Compound interest benefits savers but increases the cost of debt, credit card debt at 20% compounded monthly grows quickly
When to Use Simple Interest vs Compound Interest
As an investor or saver, always prefer compound interest, let your returns compound. As a borrower, understand compound interest to accurately assess the true cost of loans, mortgages, and credit card debt.
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Common Mistakes to Avoid
Assuming the stated annual rate is the full picture, monthly compounding at 1% is not the same as 12% annual
Underestimating how quickly debt compounds when only making minimum payments
Delaying saving, starting 10 years later can reduce your final pension pot by 40–50% due to less time for compounding
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Frequently Asked Questions
Which is better: simple or compound interest?↓
For saving and investing, compound interest is always better, your money grows faster. For borrowing, simple interest is better as it costs less over time. Most real-world financial products use compound interest.
How does compounding frequency affect returns?↓
The more frequently interest compounds, the more you earn. Daily compounding produces slightly more than monthly, which produces more than annual. The difference is small for typical savings rates but meaningful on large balances or high rates.
What is the rule of 72?↓
The rule of 72 estimates how long it takes to double your money at a given compound interest rate. Divide 72 by the annual rate. At 6%, your money doubles in roughly 12 years. At 9%, it doubles in 8 years.
Do savings accounts use simple or compound interest?↓
Almost all UK savings accounts use compound interest. Interest is typically calculated daily and credited monthly or annually. ISAs and cash savings accounts compound your returns over time.
Does credit card debt use compound interest?↓
Yes. Credit card interest is calculated daily on your outstanding balance and compounds monthly. At typical rates of 20–30% APR, an unpaid balance can double in 3–4 years even without additional spending.