Compound Interest vs. Simple Interest –– What's the Difference?
September 17, 2020
By Rahul Iyer
Investing is all about the interest. Without it, investing doesn’t make sense, right? But what type of interest is better – compound or simple?
Let’s look at the differences.
What is Simple Interest?
The name says it all – it’s simple.
You take the amount of money you invest, say $1,000, and multiply it by the interest rate. Say you can earn 5%. You’d earn $50 each year in interest. The interest doesn’t compound – you only earn interest on the money you invest.
If you kept that $1,000 in the investment for 5 years, for example, you’d earn $250 in interest, giving you a total of $1,250 at the end of 5 years.
What is Compound Interest?
Compound interest, as the name suggests, compounds, which means your interest earns interest.
Interest can compound at any frequency, but the most common is daily or monthly. Sometimes it compounds quarterly or annually, but that is less frequent. The more frequent your interest compounds, the more you earn.
Using our example from above, earning 5% on $1,000, you’d earn $1,283 after 5 years if the interest is compounded monthly. It doesn’t seem like much more than simple interest, but the longer you leave your principal in an investment with compounded interest, the more it grows.
What’s the Difference?
It may not seem like there’s much of a difference since at the same interest rate you only earn a small amount more. It comes down to your money earning money. Compound interest is a passive investment.
You don’t have to do anything and yet your investment grows. Your earnings earn interest, making your money grow much faster than simple interest investments would grow.
Which Investments offer Compound Interest?
We’ve established that compound interest is better, but which investments offer it?
You won’t’ find it on your standard savings accounts. Banks usually offer simple interest. But if you step up your game a bit, you’ll earn compound interest in things like:
High-yield savings accounts
These investments aren’t as risk-free as a savings account, but beside stocks, they don’t have a high risk level. You can invest in them knowing that you’ll walk out with your investment and typically interest too.
When you look for a bank account or CD, make sure the facility carries FDIC insurance. This protects your investment up to $250,000. If the bank or financial institution went under, you’d get your investment back.
As far as bonds, there’s a small risk of default, but it’s next to nothing. Stocks are obviously riskier, but you can minimize your risk by choosing stable stocks or buying preferred stock which is less risky than common stock.
Understanding the difference between simple and compound interest is important. You can’t retire on simple interest – the money simply won’t grow enough for you to live on it. But, compound interest is a different story – you can live on the proceeds of compound interest especially when you start early and leave your money for a long time.