Home > Personal Finance > Simple vs. Compounding Interest: How Does It Work?

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You may think of interest as a negative – when you have to pay it for taking out a loan or borrowing money with a credit card. But when you start to consider your retirement savings and investment strategies, you will realize that not all interest is bad. And not all interest is created equal. The guide below can help you understand the simple distinction between interest and compounding interest – and how that one added word could have a big effect on your financial health.

The Basics

Interest is the cost associated with borrowing money. You may pay interest to a lender for a mortgage, auto loan or credit card. Interest is typically stated as a percentage of the principal amount. Any party that borrows money typically makes interest payments on top of the agreed upon loan amount.

Consider the rate on your credit card, student loans, or mortgage as examples. High rates can become very costly very quickly, so when you are borrowing, you generally want to look for low interest-rate loans. (A good credit score helps you qualify for lower rates, so it’s a good idea to check your credit before you apply with a lender. You can pull your credit reports for free each year at AnnualCredit Report.com and see your credit scores for free each month on Credit.com.)

But, as I mentioned earlier, you can also earn interest. This is the money you earn just for keeping your money somewhere without touching it. For instance, a financial institution may pay interest on a certificate of deposit, retirement fund or simple savings account. In that case, when you are earning, generally the higher the interest rate, the better.

Simple vs. Compounding Interest

Interest can be either simple or compounded. Simple interest is determined solely on the original principal. Generally, this is a fixed rate. The formula for simple interest is the principal amount multiplied by the interest rate (by the term of the loan, if you are borrowing).

On the other hand, compound interest changes every period. Calculated by multiplying the interest rate by the principal amount plus the accumulated interest of previous periods, compound interest is often referred to as “interest on interest.”

What Does this Difference Mean for Me?

The best way to put this knowledge of the different types of interest to use is investing regularly in vehicles that feature compounding interest and taking loans out with only simple interest. Compounding interest is sometimes referred to as letting your money make money. It’s a way to increase how much money you have earning more money. It’s one of the reasons why it’s so important to begin saving for retirement early – you give your money more time to work for you.

Understanding the basic financial concepts of simple and compounding interest will give you a better idea of how to use your money and credit. It’s important to read all the fine print and be completely clear on the terms either when you are taking out a loan or making an investment.

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