Simple vs Compound Interest

The difference between interest calculated only on the original amount and interest that earns interest, with simple examples.

Interest is the price of money: what you earn for saving or pay for borrowing. There are two main ways to calculate it, and the difference can be enormous over time.

Simple interest

Simple interest is calculated only on the original amount, called the principal.

Formula in words: interest equals principal times rate times time.

If you deposit 10,000 rupees at 8 percent simple interest for 3 years, you earn 800 rupees each year, 2,400 rupees in total, giving 12,400 rupees.

Compound interest

Compound interest is calculated on the principal and on interest already earned. Interest earns interest.

With 10,000 rupees at 8 percent compounded yearly:

After year 1: 10,800 rupees.
After year 2: 10,800 plus 8 percent is 11,664 rupees.
After year 3: 11,664 plus 8 percent is about 12,597 rupees.

Compound interest gives about 197 rupees more than simple interest after 3 years. The gap grows larger over time.

Over long periods

After 30 years at 8 percent:

Simple interest: 10,000 plus 24,000 in interest equals 34,000 rupees.
Compound interest: about 100,600 rupees, around ten times the original amount.

Compounding frequency

Interest can compound yearly, quarterly, monthly or even daily. More frequent compounding means slightly more interest. Many bank deposits in India compound quarterly.

Compounding works against borrowers too

Credit card debt often compounds, so unpaid interest adds to the balance and itself attracts interest. This is why credit card debt can grow quickly.

The rule of 72

A quick way to estimate how long money takes to double with compound interest is to divide 72 by the interest rate. At 8 percent, 72 divided by 8 is 9, so money roughly doubles in about 9 years. At 12 percent, it doubles in about 6 years.

Thinking the difference is small

Over a few years, the gap between simple and compound interest is modest. Over decades, it becomes enormous, which is why starting to save early makes such a difference.

Key takeaways

Simple interest is calculated only on the original principal.
Compound interest earns interest on previous interest.
Over 30 years at 8 percent, compounding turns 10,000 into about 100,600, versus 34,000 with simple interest.
Compounding also makes unpaid debts grow quickly.