Simple interest vs compound interest: what's the difference?

What is simple interest?

Simple interest is a type of interest payment that is only calculated on the initial amount, or principal, for one period or more. This means if the original principal doesn’t change, the interest payment will remain consistent for every period.

The simple interest formula is:

Simple interest = Principal × Rate × Time

For instance, if you were to borrow £1,000 at a 5% annual interest rate over two years, you could calculate the interest as follows:

£1,000 x 0.05 x 2 = £100

So, the loan’s interest would be payable at £50 per year or £100 over two years of the loan term.

Simple interest is often more beneficial for borrowers than compound interest, as it keeps interest payments on loans consistent and lower.

This type of interest is most often used for amortised monthly car loans, consumer instalment loans, and certain bonds and savings accounts.

What is compound interest?

Compound interest is interest that is calculated both based on the initial principal amount and the interest that has been accumulated from prior periods.

The compound interest formula is:

Compound interest = P(1 + r/n)^(nt) – P

P = principal, r = interest rate, n = the number of times the interest is compounded annually, and t is the time in years.

If you were to make an investment which grew at 5% compounded annually over two years, you would calculate your interest earned:

Compound interest = £1,000 (1 + 0.05/1)^(12) – P

CI = £102.50

Compound interest grows more quickly than simple interest, as interest is effectively earned on previous interest earnings.

It’s most commonly used for investments, savings accounts, and loans such as credit cards.

Compound interest vs simple interest: what’s the difference?

Below, we’ve compared the differences between compound interest and simple interest.

Rate of growth

Simple interest grows consistently, while compound interest grows exponentially over time.

This is because simple interest is only calculated on the principal, while compound interest is calculated both on the principal and on interest earned during previous periods.

Impact on loans

Simple interest results in lower total interest expenses on loans and predictable interest costs, making it better suited to borrowers.

Compound interest payments on loans can increase over time, making them more costly, especially for long-term loans.

Impact on savings and investments

Compound interest is the most beneficial type of interest for savers and investors, as its interest payments can yield higher returns over time.

Simple interest may not grow savings and investments as quickly.

Simple interest vs. compound interest: which is better?

The best choice between simple and compound interest will depend on whether you’re borrowing money or investing it. 

Compounding interest allows the principal to grow exponentially, allowing your invested funds to grow faster.

However, when it comes to debt, compound interest can increase the amount you owe, and it’ll take you longer to pay it off. In contrast, you’ll pay less over time if you have a loan with simple interest.

Simple interest is the ideal option for short-term loans and situations where you want predictable and low-interest repayments, such as car and personal loans.

Compound interest is optimal for longer-term savings and investments. 

We recommend using compound interest for retirement savings, in particular, as compound growth will allow you to earn as much as possible for your retirement years.

Conversely, it’s recommended you avoid choosing loans with compound interest, as this can create a snowball effect that creates more debt the longer you take to pay them off. 

Practically, simple interest is used to calculate fixed repayment schedules on loans and fixed-term savings, as well as to calculate a buyer’s repayments in cases of seller financing.

For example, a seller may finance £100,000 on a car at a simple interest rate of 5% over three years. The buyer would then make regular payments with interest calculated on the original principal of £100,000 to pay off the purchase.

Generally, compound interest is used to calculate the interest earned on most savings accounts, as well as that of investments like bonds, stocks, and mutual funds. It is also used to calculate the interest accrued in mortgages. 

Your employer’s contributions to your pension pot may also be subject to compound interest. If your employer contributes 5% of your salary yearly into a pension fund, for example, your earnings will increase over time to expand your retirement nest egg.

Real-life examples: simple interest and compound interest

Taking out a loan with simple or compound interest rates can significantly affect your loan repayment values.

If you took out a simple interest loan of £2,000 at a yearly rate of 5% and a three-year term, you would pay £2,300 over the full term. In this case, your monthly interest payments owed on the loan would come to £8.33 per month.

If you took out the same £2,000 loan for 3 years at 5%, compounded yearly, you would pay £2,315.25 over the loan term. If the loan were compounded monthly, however, you would pay £8,192.00 on the same £2,000 loan – nearly triple the value of the original principal.

The results would differ considerably if you choose a savings account.

The results would differ considerably if you choose a savings account. If you invested £2,000 into a savings account with 5% yearly simple interest, after 10 years, your savings would be worth £3,000.

If you opted for a savings account with compound interest, the same investment under the same terms would grow to £3,257.79.

Get expert financial advice

Simple and compound interest each have pros and cons worth considering when taking out any type of loan.

Simple interest offers favourable interest repayments for borrowers, but compound interest offers the best returns if you want to invest and grow your wealth.

Get expert advice from a financial adviser through Unbiased to minimise your interest and maximise the potential of your loan.