Simple Interest vs Compound Interest
Simple interest is calculated only on the original principal — it doesn't earn interest on previously earned interest. The formula is: I = P × r × t (Interest = Principal × rate × time). It's linear, predictable, and commonly used for short-term loans, car loans, and some bonds.
Compound interest, by contrast, earns interest on the principal plus all previously accumulated interest. Over long time periods, the difference becomes enormous. At 7% for 30 years, $10,000 grows to $21,000 with simple interest but over $76,000 with annual compounding.
Understanding the difference matters because: borrowers prefer simple interest (lower total cost), while investors prefer compound interest (higher total return). Banks and financial products are designed with this in mind.
Frequently Asked Questions
When is simple interest used in real life?
Simple interest is common in: auto loans (most US car loans use simple interest), short-term personal loans, some government bonds and Treasury bills, and certain savings bonds. Mortgages, credit cards, and most investments use compound interest.
What is the simple interest formula?
I = P × r × t — where I is the interest earned, P is the principal (starting amount), r is the annual interest rate as a decimal (e.g. 7% = 0.07), and t is the time in years. Final amount = P + I = P(1 + r × t).
Is simple interest better than compound?
It depends on whether you're a borrower or investor. For borrowers, simple interest loans cost less over time. For investors and savers, compound interest grows wealth much faster. The longer the time period, the bigger the gap between the two.