Compound Interest vs Simple Interest

The best way for me to explain the difference between Compound Interest and Simple Interest is for me to show you by the numbers.

Let’s say you open a savings account and make a one time principle deposit of $1000.00 dollars which pays 5% percent interest annually.

(THIS IS FOR DEMONSTRATION PURPOSES ONLY)

Let’s also say (for this demonstration) that you DO NOT make any additional deposits for a period of three years. Just let the $1000.00 dollar deposit sit.

Let’s start with Simple Interest:

$1000.00 dollar principle deposit @ 5% SIMPLE INTEREST per year…

• AFTER Year One:$1000.00 dollar principle deposit x 5% simple interest equals $50.00 dollars, which results in a total of $1050.00 dollars on deposit

• AFTER Year Two:$1000.00 dollar principle deposit x 5% simple interest equals $50.00 dollars, which results in a total of $1100.00 dollars on deposit

• AFTER Year Three:$1000.00 dollar principle deposit x 5% simple interest equals $50.00 dollars, which results in a total of $1150.00 dollars on deposit

Notice a pattern?

The 5% simple interest rate is calculated and paid ONLY on the ‘principle deposit’ of $1000.00 dollars.

Since 5% percent of $1000.00 dollars equals $50.00 dollars, the account earns $50.00 dollars per year for three years, for a total of $150.00 dollars in SIMPLE INTEREST.

Therefore, after three long years, your principle deposit of $1000.00 dollars @ 5% SIMPLE INTEREST would have earned a total of $150.00 dollars.

• After 3 long and boring years, the total account balance is $1150.00 dollars.

Not so exciting.

Now, let’s rev up the earnings with COMPOUND INTEREST using the same $1000.00 dollar principle deposit:

$1000.00 dollar principle deposit @ 5% COMPOUND INTEREST per year…

• AFTER Year One:$1000.00 dollar principle deposit x 5% compound interest equals $50.00 dollars, which results in a total of $1050.00 dollars on deposit

• AFTER Year Two:$1050.00 dollar principle deposit x 5% compound interest equals $52.50, which results in a total of $1102.50 on deposit

• AFTER Year Three:$1102.50 dollar principle deposit x 5% compound interest equals $55.13, which results in a total of $1157.63 on deposit

CAN YOU FEEL THE EXCITEMENT!!!

The 5% COMPOUND INTEREST RATE is earned and paid on the ‘principle deposit’ of $1000.00 dollars in the FIRST YEAR resulting in a ‘total on deposit’ of $1050.00 dollars.

In the SECOND YEAR the 5% COMPOUND INTEREST RATE is paid on the total of $1050.00 dollars, which results in a ‘total on deposit’ of $1102.50… a difference of $2.50 cents when compared to simple interest.

After the THIRD YEAR the 5% COMPOUND INTEREST RATE is paid on the total of $1102.50, which results in a ‘total on deposit’ of $1157.63… a difference of $7.63 cents when compared to simple interest.

• After 3 years, with SIMPLE INTEREST, the total on deposit is $1150.00 dollars
• After 3 years, with COMPOUND INTEREST, the total on deposit is $1157.63 cents
• The difference between SIMPLE INTEREST versus COMPOUND INTEREST (in this example) is $7.63 cents.

Another way to make sense of this is:

• SIMPLE INTEREST allows you to earn interest on the PRINCIPLE ONLY
• COMPOUND INTEREST allows you to earn interest on the principle AND EARN INTEREST ON TOP OF INTEREST

COMPOUND INTEREST is very exciting and very powerful when you want your money to grow quickly and becomes more exciting as you continue to make regular and consistent deposits into your account, whether weekly, bi-weekly, or monthly.

Certainly it is uncommon in the year 2020 to find a ‘regular savings account’ that pays 5% interest, whether simple or compound, as I mentioned at the beginning, THIS IS FOR DEMONSTRATION PURPOSES ONLY.

However, there are many opportunities to earn 5% interest, or more, when you open an investment account, such as an IRA, Roth IRA, or a 401k investment account.

Other investment opportunities are ETF’s, Money Markets, Mutual Funds, and more.

I hope that you now have a better understanding of the difference between compound interest versus simple interest, so that you can start searching for investment opportunities that offer to compound your earnings.

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