If you invest it correctly, your money should make more money. Earning interest can be a powerful wealth-building tool, as long as time is on your side. Learn about the different types of interest-earning mechanisms to maximize your returns, because simple and compound interest are very different. Knowing if and how often interest is compounded is often critical to understanding the terms of a loan or a bank account.
Both simple and compound interest help you grow your initial investment and are relatively easy to calculate. While simple interest usually is for short-term investments and only applies to the initial principal, compound interest applies to both the principal and interest earned and is often used for longer investments.
Understanding Simple Interest
Simple interest is just that. It is interest earned at a given rate on an investment. For instance, if you invested $200 in an account that gave you a 5 percent return, at the end of one year, you would own $210.
Understanding Compound Interest
Compound interest is, in essence, interest that is added to the principal, earning interest on the full amount. The more often the interest is added, the more you earn. If you invest your $200 in an account that pays compound interest at 5 percent, compounding (adding interest) monthly, at the end of one year you would own $210.23. If instead of compounding monthly, the account compounded daily, at the end of one year you would own $210.25, since you effectively start earning interest on more money every day.
In general, if someone is paying you interest, you want interest to be compounded as frequently as possible, so that you can earn interest on that paid interest as quickly as you can. If you owe someone money, on the other hand, you'd rather see less frequent compounding so that the total net amount you end up paying is smaller.
How They're Similar
Both simple and compound interest grow your money. If you keep your account in credit, at the end of the year you will have more money than when you started. Both mechanisms reflect the cost to the bank of borrowing your money. When applied to a loan you have taken out, they reflect the cost to you of borrowing that cash.
Simple interest is generally easier to compute, though there are plenty of tools to help you compute compound interest without having to do the math yourself, including some free ones from government agencies like the Securities and Exchange Commission.
Where They Diverge
Simple interest is computed only on the principal you have invested or borrowed. Compound interest is computed on the principal, plus whatever interest has already been added. Simple interest is usually used on short-term accounts or loans. Compound interest is usually used on long-term accounts or loans. Compound interest essentially works much faster than simple interest; its growth is exponential, whereas that of simple interest is constant.