Show Me The Numbers!
Simple interest is interest calculated ONLY on the principal amount, while compound interest is interest calculated on BOTH the principal amount AND on any interest that has already accumulated.
If you would like a deeper understanding of the difference between Simple Interest and Compound Interest, read on:
Let’s say you open a savings account and make a one time principle deposit of $1000.00 dollars which pays you 5% percent interest annually.
Now let’s also say (for this demonstration) that you DO NOT make any further deposits for a period of three years.
You just let your $1000.00 dollars sit there.
(THIS IS FOR DEMONSTRATION PURPOSES ONLY)
Let’s start with Simple Interest:
Your $1000.00 dollar principle deposit @ 5% ANNUAL SIMPLE INTEREST will grow something like this:
-
AFTER 12 long months: $1000.00 dollar principle on deposit x 5% simple interest equals $50.00 dollars. Added together, you now have a total of $1050.00 dollars on deposit
-
AFTER another 12 long months: $1000.00 dollar principle on deposit x 5% simple interest equals $50.00 dollars. Add the $50 dollars to the LAST 12 months, you now have $1100.00 dollars on deposit
-
AFTER ANOTHER 12 long months: $1000.00 dollar principle on deposit x 5% simple interest equals $50.00 dollars. Add the $50 dollars to the LAST 12 months, you now have $1150.00 dollars on deposit
Notice the 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, every year, for three years.
So, after 36 long months your principle deposit of $1000.00 dollars @ 5% SIMPLE INTEREST ANNUALLY has earned you a total of $150.00 dollars giving you a total balance of $1150 dollars.
To calculate the simple interest earned for this example, you would multiply the principal ($1,000) by the annual percentage rate (5 percent) by the number of years (three):
$1,000 x 0.05 x 3 = $150
Take the principle on deposit ADD the interest earned EQUALS Total Balance:
$1000 + $150 = $1150
Well that’s no fun.
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 principle balance x 5% compound interest equals $52.50, which results in a total of $1102.50 on deposit
-
AFTER Year Three: $1102.50 principle balance x 5% compound interest equals $55.13, which results in a total of $1157.63 on deposit
CAN YOU SEE THE DIFFERENCE?!
After the FIRST YEAR the 5% COMPOUND INTEREST RATE is earned and is paid on the ‘principle ONLY’ of $1000.00 dollars, resulting in a ‘total on deposit’ of $1050.00 dollars.
In the SECOND YEAR the 5% COMPOUND INTEREST RATE is paid on BOTH the PRINCIPLE and the INTEREST 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 BOTH the PRINCIPLE and the INTEREST 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 see this is:
-
SIMPLE INTEREST allows you to earn interest on the PRINCIPLE ONLY
-
COMPOUND INTEREST allows you to earn interest on the principle AND the interest combined, which means that YOUR MONEY EARNS INTEREST ON TOP OF INTEREST
COMPOUND INTEREST is very exciting and very powerful when you want your money to grow quickly, and this becomes even more exciting as you continue to grow your principle balance by consistently making deposits into your account throughout the year, either weekly, bi-weekly, or monthly.
Interest rates at banks, credit unions, and investment banks can change, which impact many financial products, so it is important to stay vigilant and look out for where the best interest rates are being offered for your money.
Consider the many other financial products that are available for you and your money that you can have access to through an investment account, such as an IRA, Roth IRA, 401k, ETF’s, Money Market Accounts, Mutual Funds, and more.
Your money should never stand still.
I do believe that it is your responsibility, in fact, it is YOUR JOB, to make your money grow.
Understanding the big difference between compound interest versus simple interest is a great place to start.
Be on the look out for investment opportunities that offer to compound your savings and grow your money.