Why is compound interest better than simple interest?
If you’re an investor looking to understand the benefits of compound interest, consider the example set by the legendary Warren Buffett. The 93-year-old’s net worth has grown to $137 billion over the decades, thanks largely to the effects of compound interest on his long-term investments.
Buffett, like any other investor earning compound interest, is paid interest not just on his principal, but also on his previously earned interest. Money earning compound interest grows more quickly than money earning simple interest.
In this article, we’ll define simple and compound interest, with examples of each and ways to reap the benefits of compound interest.
What is simple interest?
Simple interest is calculated solely on the principal, which is the money you deposit into your investment account. Because it doesn’t account for compounding, you won’t earn interest on the money you’ve accumulated in interest.
Some bonds are structured to pay simple interest. Various lending products also charge simple interest, such as some mortgages, some vehicle loans and some federal student loans. For these simple interest loans, the interest is determined based on the principal amount instead of the principal and interest combined.
Simple interest example
Say you take out a five-year loan for $5,000 that charges a simple interest rate of 5 percent per year. Over the life of the loan, you’d have to pay back the $5,000 principal, plus $1,250 in interest, for a total of $6,250.
To calculate the simple interest for this example, you’d multiply the principal ($5,000) by the annual percentage rate (5 percent) by the number of years (five): $5,000 x 0.05 x 5 = $1,250
What is compound interest?
“Compound interest is the eighth wonder of the world,” is a quote commonly attributed to Albert Einstein. Ultimately, it’s unknown whether the famous physicist truly ever uttered those words. What is certain, however, is that your money will grow faster in an investment or bank deposit account that earns compound interest rather than one earning simple interest.
Unlike simple interest, compound interest involves earning interest on interest. In other words, you’re not only earning interest on your principal, but also on the interest you’ve previously earned.
Accounts that earn compound interest include:
Bonds and bond funds (when the interest paid is reinvested)
For compound interest loans, the interest is based on the principal and the interest combined. Types of loans that often charge compound interest include:
Credit cards that carry a balance
Student loans that are being deferred
Compound interest example
Most savings accounts, money market accounts and CDs earn compound interest.
For example, a fixed-rate, five-year CD may offer an interest rate of 3.68 percent and an annual percentage yield (APY) of 3.75%. (The APY refers to the compound interest.) If you deposited $10,000 into this account, you’d have earned around $183 more when the five-year term ended, thanks to the interest compounding.
The formula for compound interest is:
Initial balance × ( 1 + ( interest rate / number of years ) )number of years x compounded periods per year
Alternatively, Bankrate’s compound interest calculator can come in handy in determining how much you can earn when you enter information such as a dollar amount, APY and time frame.
How simple interest and compound interest differ
When it comes to most savings accounts and some other investments, simple interest consists of interest earned on the principal amount and not on the interest that’s earned. Conversely, compound interest for these accounts comprises interest earned on both the principal and the interest.
For loans, simple interest is based on only the principal amount, whereas compound interest is based on the principal and interest combined.
A savings account grows more quickly by earning compound interest than simple interest. Likewise, a loan becomes more expensive for the borrower when it’s based on compound interest than simple interest.
Therefore, it can be said that compound interest is favorable for savers, while simple interest is preferable for borrowers.
How to take advantage of compounding
You’ll earn compound interest — when the interest you earn, earns interest — on most savings accounts, money market accounts, CDs and interest-bearing checking accounts. It pays to shop around for the best rate because APYs can vary widely among banks. Online-only banks tend to offer significantly higher yields than brick-and-mortar banks.
Bottom line
Compound interest helps accelerate how fast your money grows in savings accounts and other investments. Likewise, compounding increases the amount of total interest you’ll owe on a loan.
Understanding how compound interest works, and how it’s different from simple interest, can help you make decisions on the best ways to borrow and save.