How Interest Works: Simple vs. Compound
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In short
Interest is the price of money — what you earn when you lend or save it, and what you pay when you borrow. It comes in two forms: simple interest, calculated only on the original amount, and compound interest, calculated on the original amount plus all the interest already accumulated.
That one difference — whether interest earns interest — is what makes compound interest so powerful over time, working spectacularly in your favour when you save and painfully against you when you borrow.
Here's how each type works, why the gap between them widens over time, and why it's the same force whether you're earning or paying.
Interest, in one line
Interest is a rent on money. When you keep money in a savings account, the bank pays you interest for the use of your deposit. When you take a loan, you pay the lender interest for the use of theirs. Either way, it's usually expressed as an annual percentage rate. The direction differs; the mechanics are identical.
Simple interest
Simple interest is calculated only on the original principal, period after period. It doesn't build on itself. The formula is straightforward: principal × rate × time.
Put $1,000 in something paying 5% simple interest and you earn $50 every year — year one, year ten, every year the same $50, because it's always 5% of the original $1,000. Some loans and bonds work this way. It's predictable and linear: a straight line.
Compound interest
Compound interest is calculated on the principal plus all the interest already earned. Each period, the base grows, so each period earns a little more than the last — as covered more fully in compounding and the time value of money.
The same $1,000 at 5% compound interest earns $50 the first year — but the second year it earns 5% of $1,050, or $52.50, and the third year 5% of $1,102.50, and so on. Each year the amount grows faster. It's not a straight line; it's a curve that bends upward. How often interest compounds (yearly, monthly, daily) also matters — more frequent compounding means slightly faster growth, which is why savings accounts advertise an APY (annual percentage yield, which reflects compounding) rather than just a rate.
Worked example: simple vs. compound on $10,000 at 6%
Simple interest (6% of the original $10,000 every year = $600/year):
- After 10 years: $10,000 + (10 × $600) = $16,000
- After 30 years: $10,000 + (30 × $600) = $28,000
Compound interest (6% on the growing balance each year):
- After 10 years: about $17,908
- After 30 years: about $57,435
At 10 years the gap is modest (~$1,900). By 30 years, compound interest has produced more than double what simple interest did — an extra ~$29,000 from nothing but interest earning its own interest. The longer the time, the wider the gap. That's the whole case for starting early.
The same force cuts both ways
Here's the crucial point most people miss: compound interest is not just a saver's friend — it's a borrower's enemy. The exact mechanism that grows your savings grows your debts. A credit-card balance compounds against you: unpaid interest is added to what you owe, and then that accrues interest too. It's why a modest balance left unpaid can balloon, and why paying down high-interest debt is so valuable — you're switching the compounding from working against you to working for you. When you save, you want compound interest. When you borrow, you want to escape it fast.
Frequently asked
5 questions
What's the difference between simple and compound interest?
Simple interest is calculated only on the original amount, so it earns the same amount each period. Compound interest is calculated on the original amount plus the interest already accumulated, so it earns a little more each period — growing as a curve rather than a straight line.
Why is compound interest so powerful?
Because interest earns interest, the growth accelerates over time. Early on the difference from simple interest is small, but over decades compound interest can produce more than double the result — which is why starting early matters so much.
What's the difference between APR and APY?
Broadly, APR (annual percentage rate) expresses a yearly rate without accounting for how often interest compounds, while APY (annual percentage yield) reflects compounding, so it shows the true annual return on savings. More frequent compounding raises the APY above the stated rate.
Does compound interest work against me on debt?
Yes. The same mechanism that grows savings grows debt. On something like a credit card, unpaid interest is added to your balance and then itself accrues interest, so a balance can grow quickly — which is why paying down high-interest debt is so valuable.
How often does interest compound?
It varies by product — yearly, monthly, or daily are common. More frequent compounding means slightly faster growth for the same rate, which is why comparing the APY (which reflects compounding) gives a fairer picture than the headline rate alone.
References
- U.S. Securities and Exchange Commission — Compound Interest Calculator (investor.gov) (accessed 2026-08-13)
- Consumer Financial Protection Bureau (CFPB) — What is the difference between a loan interest rate and the APR? (accessed 2026-08-13)
Educational and informational only — not investment advice, a recommendation, or an offer to buy or sell any security. Investing involves risk, including the possible loss of principal. Worked examples use fictional companies and figures.