What is the difference between simple and compound interest?

Simple interest is calculated only on the original principal: $5,000 at 6 percent for 20 years becomes $11,000. Compound interest is calculated on the principal plus accumulated interest, so the same terms become $16,036. The $5,036 gap is the interest that earned its own interest.

Which is better, simple or compound interest?

It depends on which side of the deal you are on. When you are saving or investing, compounding is better because your money grows faster. When you are borrowing, simple interest costs you less, because the lender never charges interest on the interest.

How do you calculate simple interest?

Simple interest = principal x rate x time. $5,000 at 6 percent for 20 years is 5,000 x 0.06 x 20 = $6,000 of interest, for a total of $11,000. There is no compounding: the interest never joins the balance.

Why does the gap between simple and compound interest grow over time?

Because compound interest grows exponentially while simple interest grows in a straight line. At 10 percent over 30 years, $5,000 of simple interest reaches $20,000 while compounding reaches $87,247: the gap is $67,247, far bigger than it was at year 10.

Do savings accounts use simple or compound interest?

Almost all savings accounts, CDs, and money market accounts compound, usually daily or monthly. Simple interest shows up mostly in short-term instruments like some Treasury bills, certain personal loans, and car loans with precomputed interest.

Compounding vs Simple Interest: Which One Grows Your Money?

Two ways to pay interest, two wildly different outcomes. One example will show you the gap better than any definition.

Simple interest pays only on the original principal: $5,000 at 6 percent for 20 years becomes $11,000. Compound interest pays on the principal plus all accumulated interest, so the same terms become $16,036. The $5,036 gap is interest earning its own interest. Over longer horizons the gap explodes: at 10 percent for 30 years, the same $5,000 reaches $20,000 simple versus $87,247 compounded. When you save, compounding is your ally; when you borrow, simple interest is cheaper.

The two formulas

Simple interest: FV = P x (1 + r x t). The interest each period is always P x r, paid on the original amount only. Nothing earned ever starts earning.

Compound interest: FV = P x (1 + r)^n. The interest each period is r times the current balance, which includes everything earned so far. Every payment starts pulling its own weight.

The formulas look almost identical. The difference is one symbol: a multiplication in the simple version, an exponent in the compound version. That exponent is the whole story of modern saving.

Side by side: $5,000 at 6 percent for 20 years

Year	Simple interest balance	Compound interest balance	Gap
1	$5,300	$5,300	$0
5	$6,500	$6,691	$191
10	$8,000	$8,954	$954
15	$9,500	$11,983	$2,483
20	$11,000	$16,036	$5,036

Year 1 is a tie: compounding has not had anything to compound yet. By year 5 the gap is $191, barely visible. By year 10 it is $954. By year 20 it is $5,036, nearly the size of the original deposit. The gap itself accelerates, because the gap is compounding too. This is the shape everyone should have in their head: slow start, explosive finish.

The same comparison at 10 percent for 30 years

Raise the rate and the horizon and the difference stops being a gap and becomes a different world. $5,000 at 10 percent:

Measure	Simple interest	Compound interest
Balance after 30 years	$20,000	$87,247
Multiple of original deposit	4x	17.45x
Interest earned	$15,000	$82,247

Compound interest produces more than four times the balance of simple interest here, and $67,247 of the difference is interest on interest. At higher rates over long horizons, the original deposit becomes a footnote. Nearly everything in the final balance is the work of compounding.

Which side do you want to be on?

When you are the saver, compounding is strictly better. That is why savings accounts, CDs, and retirement accounts all compound: your balance grows on an exponential curve instead of a straight line. The difference between 6 and 8 percent compounded over 30 years is far larger than the difference between the same two rates under simple interest.

When you are the borrower, simple interest is strictly cheaper. A loan with simple interest charges you only on the principal, so paying it down early saves less than paying down a compounding loan early. This is the one situation where you should root for the boring formula. It is also why carrying a balance on a compounding credit card is so punishing: the lender is on the exponential side and you are not.

Inflation gives a third angle. Prices compound too, which is why a 3 percent inflation rate cuts purchasing power roughly in half every 24 years (72 / 3). The rate of return that matters is not the nominal one on the account statement but the real one after inflation, and the future value formulas cannot tell you that until you feed them a real rate.

Where simple interest still shows up

Almost every savings product compounds, so simple interest is easy to dismiss as a textbook fossil. It still appears in short-term Treasury bills, some personal and auto loans with precomputed interest, and many "0 percent for 12 months" style arrangements where the balance is short-lived anyway. Over short horizons the two formulas agree closely, which is exactly why simple interest survives there. It only loses badly when time gives compounding room to run.