Compound vs. Simple Interest
Posted on 04/16/2015
By Mark A. Gajowski II, CFP & Founder
I know this may be overly simple for some (no pun intended), but it’s worth explaining as it can have an extreme difference on your future life if you capitalize on it early. As Yogi Berra once said, “I think a lot about the future, as that’s where I’m going to spend the rest of my life.” Of course, we believe that too, and why we want to encourage you to really understand the differences herein.
Wouldn’t it be amazing if you could make money while you sleep? Believe it or not, you can! All you need to do is save some of your money (hyperlink) by depositing it into a bank account that pays interest.
Interest is the money that you “earn” for investing your hard-earned money (it’s a risk-metric). Less interest for less risk, more (hopefully) for more. To understand how this works, let’s learn the difference between receiving no interest and receiving either simple interest or compound interest.
For example, let’s say you put $100 in your mattress. Over time, if you don’t spend any of it, you’ll still have $100 in your mattress, right?
Because your mattress is not a real account, it doesn’t pay you interest. It just holds your money which doesn’t grow over time. You’ll always have exactly the same amount you started with (but less in actually purchasing power due to inflation, another subject entirely).
Instead, let’s say that you deposit your $100 into an account that pays simple interest quarterly. Your $100 is called the “principal.” “Simple interest quarterly” means you are earning simple interest on your $100 four times a year.
If your earn 5% interest, that means every three months (quarterly), you earn $5 (5 percent of your original $100) in simple interest. After a year, you’ll have $120 ($100 — your principal — plus $5 for each quarter in the year).
Simple interest is a pretty good deal. But there’s an even better deal, one that Albert Einstein called the 8th Wonder of the World and the Most Powerful Invention ever Created by Man! Let’s see what happens when you earn compound interest.
Compound interest is very similar to simple interest. The difference is that instead of paying interest on your original $100 every quarter, the bank instead will add each interest payment to the principal.
That means you end up earning interest on your interest (or money on your money). When this happens, it is said that your money is “compounding.” Let’s do some math to see the difference this makes. You start with $100 in an account that pays 5% compound interest, quarterly.
At the end of the first quarter (three months), you earn $5 (5 percent of $100). Your new principal balance is $105. At the end of the second quarter, the account pays you 5% interest again. This time, though, it pays interest on your principal balance of $105.
Since 5 percent of $105 equals $5.25, adding that $5.25 to your account. Your principal balance goes up to $110.25 ($105 plus $5.25 in compound interest). If you do the same math for the third and fourth quarters, you’ll find that your principal balance at the end of a year is $121.55. With 5% simple interest, you had $120 in your account at the end of a year. With 5% compound interest, you earned an extra $1.55.
As you can see, compound interest helps your money grow faster because it pays interest on your interest over time. That extra $1.55 may not sound like a lot of money right now, but your account has only earned compound interest for one year. This effect multiplies over time and can have a very dramatic effect.
The more money you put in your account, the more interest will accrue. The longer you leave your money in your account, the more compound interest it will earn over time. For as we know, it’s about time in the market and NOT market “timing” (or waiting for the time to be “right” to invest)!