Simple vs. compound interest: The differences explained
Simple and compound interest are common terms you see for financial products. Interest is fundamental to banking and finance, whether you want to borrow money or earn extra income. Some investments and products have simple interest, while others have compound interest. These terms are quite different, and it’s essential to understand the differences to manage your finances.
Read our guide to learn the differences between simple interest vs. compound interest and where you can see real-life examples.
How does simple interest work?
Simple interest is calculated on the principal amount (the original amount borrowed or deposited into an investment). You may see simple interest on certificates of deposit, coupon-paying bonds, and consumer loans. You can also find simple interest in some investment products, where you earn interest based on the amount you deposit only. Simple interest is a percentage showing what you pay or earn over one year.
Let’s say you borrow $2,000 from a financial services provider, and the simple interest rate is 1% over a one-year loan term. At the end of the year, you pay $20 in interest to the institution on your loan. You pay the simple interest amount every year until your loan term ends.
Simple interest formula
Simple interest formula = Principal amount x interest x Loan term
The simple interest formula only has three components. You can calculate it by multiplying the principal, interest rate, and loan term. In our example above, the principal is $2,000, the interest rate is 1%, and the loan term is one year. If the loan term is three years, you would pay $60 in interest. You can use this formula to calculate how much interest you would pay when you borrow money.
How does compound interest work?
Compound interest is calculated on the principal amount and accumulated interest from previous periods. It can generate much more interest than simple interest. You typically find compound interest on savings accounts and mortgages. Compound interest can make your funds grow faster in a savings account or make your loan repayments more expensive.
You get compound interest based on the compounding period, like daily, monthly, quarterly, semi-annually, or annually. The compounding period determines the frequency at which interest is added to your account. For example, monthly compounding means the interest is added to your account balance monthly—the more frequent the compounding period results in more compound interest.
Let’s say you have $2,000 earning 1% interest in a savings account compounded monthly. The total compound interest amount is $20.09 at the end of one year.
Compound interest formula
Compound interest formula = P (1+r/n)nt
The compound interest formula is more complex than simple interest. P refers to the principal, r is the interest rate, n is the compounding frequency, and t is the number of time periods. In the compound interest example, P is $2,000, r is 1%, n is 12 (once per month), and t is one year.
What is the difference between simple interest vs. compound interest?
The main difference between simple and compound interest is that you calculate simple interest only on the principal amount, while compound interest also considers the accumulated interest from previous periods. Compound interest works in your favour when you save money, but it can cost you much more than simple interest when taking a loan. Simple interest is less costly for borrowers as interest payments are calculated based on the principal amount.
Compound interest grows your money faster than simple interest as your balance grows every compounding period. Interest for the following period is calculated on the higher account balance each time. You can take advantage of the accelerated growth power of compound interest to help your funds grow faster in a savings account to make any purchases you want.
Real-life applications of simple interest
Some loans use simple interest to determine how much a borrower pays on a principal amount from a financial services provider. Here are some common examples you may encounter.
Car loan
When you have a car loan, like when you lease or finance a vehicle, you pay fixed monthly payments. Suppose you have a $50,000 car loan at 3% interest rate for a five-year term. You make monthly payments to the auto dealership. Using the simple interest formula, p is $50,000, i is 3%, and n is 1. The total interest on the car loan is $7,500.
The amount you pay each month to the auto dealership is based on the loan's outstanding principal balance. Your interest payments decrease over time as the outstanding balance on the loan decreases as well. As you pay more of your loan, a larger percentage of your payment goes toward the principal rather than interest.
Short-term personal loans
A short-term personal loan is any loan made from a financial provider that you repay in a year or less. You must repay the principal amount borrowed and the total interest charged.
Let’s say you take out a short-term personal loan for $10,000 to renovate your basement. The financial services provider lends you the money, and you must repay it at the end of one year. The interest rate on the personal loan is 2.5%. The principal is $10,000, the interest rate is 2.5%, and the term is one year. Based on the simple interest formula, you pay $250 in interest over the loan term.
Real-life applications of compound interest
Many investments, loans, and other financial products use compound interest to determine how much you pay on a loan or how much you earn on your investment. Here are some real-life examples of compound interest you may encounter.
Interest in a savings account
When you deposit funds into a savings account, the institution pays interest into your account. The funds in your account grow faster after each compounding period as interest is determined based on the total account balance, which includes your deposits and interest from previous periods.
Let’s say you open a high-interest savings account with a 4% annual interest rate compounded monthly. We can use the compound interest formula to determine how much interest you’ll get in a year if you deposit $2,500. P is $2,500, r is 4%, n is 12, and t is one year. You receive $101.85 in interest in your account.
If you make additional deposits into your account, the total balance grows, and the total interest you earn increases. Using the same high-interest savings account example, let’s say you deposit $100 into your account each month in addition to your initial deposit. The total compound interest you earn is $124.10, your contributions total $3,700, and your account balance is $3,824.10.
Many people like to use high-interest savings accounts for specific purchases they want to make, such as buying a new car or making a down payment. Earning compound interest helps their funds grow faster to reach their goals quickly.
Return on your investments
Many investments, like mutual funds, stocks, and exchange-traded funds, use compound interest. If you have an investment account and purchase these products, your investments will gain compound earnings over time. If you have $5,000 invested in stocks that pay a return of 7.00% over five years, you can use the compound interest formula to calculate the interest you earn–$2,012.76 in interest.
You may see the term compound annual growth rate (CAGR), which calculates a single growth rate over a period. You can use a compound annual growth rate to determine how much your investment grows over time and how early you should start investing to reach a specific goal. For example, you can estimate how long it takes for you to save for retirement based on how much money you want to have. A 25-year-old has more time to save for retirement and can save less each year than a 40-year-old.
A younger individual also has more opportunities to grow their savings and investments. If you don’t have a lot of cash to invest right now, you can gradually increase your savings and investments as your financial situation improves over the years. For example, if you get a promotion and your salary increases, you may consider investing more money into your savings and retirement plan.
Determine your risk tolerance
You can calculate the potential return on an investment based on the principal deposit and compound interest rate. It is important information to help you decide whether you want to pursue a financial decision or not. You can weigh your options to determine the best choices to make based on your situation.
Wrapping Up The Difference Between Compound Interest Vs. Simple Interest
Both compound and simple interest have important roles in finance and banking. Simple interest only considers your principal, while compound interest considers your principal and accumulated interest from previous periods. Whether you’re borrowing or lending money, you can use simple and compound interest formulas to determine how much interest you’ll earn or pay on your money. Canadians looking to maximize their savings and earnings can benefit from the snowball effect of compound interest on their bank accounts and investments.
Regardless of your financial goals, compound interest can help you reach your milestones faster. For example, if you want to save money to go to Greece with your family next year, you can use a high-interest savings account to make it happen. If you want to make a down payment in a few years, compound interest can help maximize your earning potential. By depositing money regularly in your savings account, compound interest helps your funds grow at an ever-accelerating rate over time.
The Neo High-Interest Savings account offers many perks for account holders. With a compounding interest rate of 4%¹ on every dollar, your money works hard to maximize your savings. Open multiple high-interest savings accounts and personalize them with names and icons for individual savings goals. Easily track your savings progress and make deposits or withdraw funds with the intuitive Neo app.
Ready to start earning high interest on your funds? Canadian residents 13 years and above³ are eligible. It only takes a few minutes to complete the Neo High-Interest Savings account application, and you can get started right away!
¹ Interest is calculated daily on the total closing balance and paid monthly. Rates are per annum and subject to change without notice.
² The Neo High-Interest Savings account is provided by Peoples Bank of Canada, a CDIC member institution, and is eligible for CDIC deposit protection. Deposits held in Neo High-Interest Savings accounts are combined with eligible deposits held at Peoples Bank of Canada, for up to $100,000 of deposit protection, per category, per depositor. For more information about CDIC deposit insurance, please consult CDIC’s website cdic.ca.
³ Account only available to Canadian residents. You must be at least 13 years of age if you reside outside of Quebec; if you reside in Quebec you must be at least 14 years of age.**
