Simple Interest vs. Compound Interest: What to Know - SmartAsset (2024)

FAQs

Simple Interest vs. Compound Interest: What to Know - SmartAsset? ›

With compounding interest, you'll earn more interest in less time. That's not the case with simple interest, which doesn't measure the interest you'll earn on top of the interest you've already earned in the past. Here's another example.

Interest can be calculated in two ways: simple interest or compound interest. Simple interest is calculated on the principal, or original, amount of a loan. Compound interest is calculated on the principal amount and the accumulated interest of previous periods, and thus can be regarded as “interest on interest.”

It depends on whether you're saving or borrowing. Compound interest is better for you if you're saving money in a bank account or being repaid for a loan. If you're borrowing money, you'll pay less over time with simple interest. Simple interest really is simple to calculate.

Here's how $75,000 might grow in a year based on how it's invested: Stocks – at a 7% annualized rate of return would produce $5,250. Bonds – at a 2.5% annualized rate of return would produce $1,875. Real estate – at a 10% annualized rate of return would produce $7,500.

When it comes to investing, compound interest is better since it allows funds to grow at a faster rate than they would in an account with a simple interest rate. Compound interest comes into play when you're calculating the annual percentage yield. That's the annual rate of return or the annual cost of borrowing money.

Simple interest is calculated based on your original investment or principal as opposed to compound interest which is calculated on the principal plus any accumulated interest.

When you invest, your account earns compound interest. This means, not only will you earn money on the principal amount in your account, but you will also earn interest on the accrued interest you've already earned.

$300,000 can last for roughly 26 years if your average monthly spend is around $1,600. Social Security benefits help bolster your retirement income and make retiring on $300k even more accessible. It's often recommended to have 10-12 times your current income in savings by the time you retire.

“With a nest egg of $100,000, that would only cover two years of expenses without considering any additional income sources like Social Security,” Ross explained. “So, while it's not impossible, it would likely require a very frugal lifestyle and additional income streams to be comfortable.”

Once you have $1 million in assets, you can look seriously at living entirely off the returns of a portfolio. After all, the S&P 500 alone averages 10% returns per year. Setting aside taxes and down-year investment portfolio management, a $1 million index fund could provide $100,000 annually.

What is the miracle of compound interest? ›

Compounding is the process whereby interest is credited to an existing principal amount as well as to interest already paid. Compounding thus can be construed as interest on interest—the effect of which is to magnify returns to interest over time, the so-called “miracle of compounding.”

Disadvantages Explained

Works against consumers making minimum payments on high-interest loans or credit card debts: If you only pay the minimum, your balance could continue growing exponentially as a result of compounding interest. This is how people get trapped in a "debt cycle."

Disadvantages of Simple Interest

Ignoring the Time Value of Money: Simple interest does not account for the time value of money, which is the concept that a dollar received or paid today is worth more than the same dollar received or paid in the future due to the opportunity cost of using the money elsewhere.

What is the difference between how simple and compound interest are paid? Simple interest is paid on the principal only, compound interest is paid on both principal and interest.

With simple interest, you would add 5% of $100 - $5 - each year for 10 years, for a total of $50 worth of interest. You would end up owing $150 after 10 years. If you were paying 5% interest compounded annually, though, you would take 5% of the amount each year - including any interest that has already accumulated.

Grasping the difference between simple interest and compound interest is crucial in financial decision-making. Simple interest involves calculating interest solely on the principal amount, while compound interest considers both the principal and accrued interest.

Simple interest involves interest calculated only on the principal. Compound interest is interest computed on the original principal as well as on any accumulated interest.