When you are considering loan options, it is important to understand the difference between simple interest vs compound interest. Although the interest rates may seem similar, the between could equate to thousands of dollars over the course of your loan. 

Here’s what you need to know about simple interest vs compound interest. 

What is simple interest vs compound interest?

First things first, let’s take a minute to discuss interest rates. The interest on a loan is the cost of borrowing the funds. Essentially, as the borrower, you pay the lender for the privilege of taking out a loan. The lender is rewarded for the loan with interest payments and the borrower has the opportunity to buy something that they otherwise couldn’t afford. Overall, it can be a good situation for both sides of the deal. 

However, it is critical to consider the interest rate as a factor before taking out a loan. Depending on the interest rate associated with the loan terms, you could be paying a significant amount of money in interest payments. 

With that, you’ll need to understand the difference between simple interest vs compound interest to make the right decision for your loan options. Let’s take a closer look. 


What is a simple interest rate?

Simple interest is calculated based on the original amount of the loan, otherwise known as the principal. Typically, simple interest loans offer short loan terms. Overall, simple interest is easy to calculate. 

The simple interest rate formula is:

Simple interest = Principal x Annual interest rate x Loan term in years. 

When you are presented with a loan opportunity with a simple interest rate, you should be able to easily calculate the total amount of interest for the loan. In most cases, the loan term will be clearly stated along with the other details. Let’s take a minute to walk through a few examples.

Simple Interest Rate: Example 1

Let’s say that you plan to take out a loan to cover your auto purchase. You plan to borrow $20,000 with an annual interest rate of 5%. The loan term is 5 years. 

With that, you would use the simple interest rate formula as follows:

Simple interest = $20,000 x 0.05 x 5

Simple interest = $5,000

That means that you would pay $5,000 in interest over the course of the loan. Overall, the total amount paid for this loan is $25,000. 

Simple Interest Rate: Example 2

Let’s say that you plan to take out a loan to cover your student tuition. You plan to borrow $5,000 with an annual interest rate of 7%. The loan term is two years. 

With that, you would use the simple interest rate formula as follows:

Simple interest = $5,000 x 0.07 x 2

Simple interest = $700

That means that you would pay $700 in interest over the course of the loan. Overall, the total amount paid for this loan is $5,700. 

Simple Interest Rate: Example 3

Let’s say that you plan to take out a loan to cover your first home purchase. You plan to borrow $250,000 with an annual interest rate of 3%. The loan term is 15 years. 

With that, you would use the simple interest rate formula as follows:

Simple interest = $250,000 x 0.03 x 15

Simple interest = $112,500

That means that you would pay $112,500 in interest over the course of the loan. Overall, the total amount paid for this loan is $362,500. 

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What is a compound interest rate?

In contrast to the simple interest rate, a compound interest rate is a little bit more complicated. But compound interest is more widely used by lenders providing funds. 

When compound interest is in use, the interest is calculated at regular intervals and includes any previously accumulated interest. The most common compound interest intervals are annual, quarterly, monthly, weekly, and daily. 

The compound interest rate formula is:

Compound interest = Principal x [(1 + interest rate)^number of compounding periods per year – 1]

Compound Interest Rate: Example 1

Let’s say that you plan to take out a loan to cover your auto purchase. You plan to borrow $20,000 with an annual interest rate of 5% which compounds daily. The loan term is five years which you plan to repay every month. 

With that, you would use the compound interest rate formula as follows:

Compound interest = $20,000 x [(1+0.05)^365 -1]

Compound interest = $2,651.03

That means that you would pay $2,651.03 in interest over the course of the loan. Overall, the total amount paid for this loan is $22,651.03. 

Compound Interest Rate: Example 2

Let’s say that you plan to deposit funds into a high yield savings account to start your emergency fund. You plan to deposit $5,000 with an annual interest rate of 1.5% which compounds daily. You plan to keep the funds on hand in this account for three years. 

With that, you would use the compound interest rate formula as follows:

Compound interest = $5,000 x [(1+0.015)^365 -1]

Compound interest = $230.13

That means that you would earn $230.13 in interest over the three years. Overall, your savings will have reached $5,230.13 by the end of three years. 

Compound Interest Rate: Example 3

Let’s say that you plan to deposit funds into an investment opportunity. You plan to deposit $100,000 with an annual interest rate of 5% which compounds on a daily basis. You plan to keep the funds in this account for 20 years. 

With that, you would use the compound interest rate formula as follows:

Compound interest = $100,000 x [(1+0.05)^365 -1]

Compound interest = $171,809.57

That means that you would earn $171,809.57 in interest over the three years. Overall, your savings in this investment vehicle will have reached $271,809.57 by the end of twenty years.


When to use simple interest vs compound interest

As you can see from the examples above, the difference between simple interest and compound interest can be dramatic. Although simple interest can be easier to calculate, compound interest offers more opportunity for growth. 

The different loans available to you will offer either simple or compound interest. As you explore your options, you can use the different formulas appropriately. 


Simple interest vs compound interest: which is better?

There is no simple answer when it comes to determining which of these options is better. The answer will depend on your unique situation. 

In general, the borrower has more to gain from a simple interest transaction. As an investor, you find that compound interest is better because your funds will be able to grow at a faster rate. 

 

The bottom line

Understanding the difference between simple interest and compound interest is an important part of managing your finances. With this knowledge, you’ll have a better idea of how financial decisions involving interest rates will impact your financial future.

As you work on building a solid financial foundation, take a few minutes to read our Personal Finance 101 guide. You’ll learn the ins and outs of building a financial foundation that will stand the test of time.