You probably already know that if you put money into a savings account, you’ll earn interest on it. What you might not know is the difference between that type of interest, which is also known as simple interest, and compound interest.
At Addition Financial, we work with our members every day to help them meet their financial goals. A key factor is understanding simple interest vs. compound interest. With that in mind, we’ve put together this guide to help you understand how each type of interest works and which is better for you.
What’s the Difference Between Simple (Non-Compounding) Interest and Compound Interest?
Let’s start with an explanation of the key difference between simple and compound interest. Simple interest is earned only on the principal of a balance. An example of simple interest might be demonstrated with a balance in a traditional savings account. If you deposit $5,000 and earn 0.06% in interest, you would earn $30 in interest annually. The interest is calculated using only your initial deposit. Your $30 APY would remain the same unless your financial institution changed the interest rate or you deposited additional funds.
By contrast, a compound interest rate is interest that is added to the initial deposit and can earn interest. Using the same interest as in the example above and assuming the interest compounded annually, you would earn $30 in compounded interest that would then be added to your principal balance, giving you a new total of $5,030. The next year, you would earn 0.06% interest on $5,030, which would total $30.18. In other words, compound interest is interest earned on interest.
What you can see is that on a small balance, the difference that compound interest makes initially is small. However, if you leave the money in place, the earnings will increase over time, allowing your money to grow more quickly than it would in an account with simple interest. In most cases, savings accounts offer simple interest while money market accounts and some other types of investment accounts offer compound interest.
We should also note that compound interest is used in lending. Just as having an account with compound interest can help you save more money over time, borrowing with compound interest costs you more money over time. Most lenders compound interest daily for mortgages. We’ll talk later about some strategies you can use to minimize the amount of interest you pay when you buy a house.
How Often is Interest Compounded?
Now that you understand what compound interest is, you’ll also need to understand when interest is compounded and how that can impact your savings or investments.
Simple interest may be added at intervals. Many savings accounts add interest at the end of the month or quarter. The same is true of compound interest, which may be compounded at different intervals, including daily, weekly, monthly and quarterly.
Why does that matter? If you consider the definition of compound interest, it may be easy to understand why more frequent compounding would be to your advantage. If interest is compounded on a quarterly basis, that means the amount in your bank account that earns interest will increase once every three months. By contrast, if it compounds monthly, your principal sum will increase every month.
Let’s say you had $5,000 in a money market account with a 5% interest rate that compounded quarterly. In your first quarter, you would earn $62.50 in interest, making your new balance $5,062.50. You would then earn $63.28 in interest in the next quarter, increasing your balance to $5,125.78 and so on.
Now, say you had that same $5,000 in an account with 5% interest that compounded monthly. In your first month, you would earn $20.83 in interest. With a new principal balance of $5,020.83, you would earn $20.92 in interest your second month. That might not seem like much, but the account with monthly compounding would out-earn the account with quarterly compounding within eight months. The account with quarterly compounding would have a balance of $5,254.73 after one year, and the account with monthly compounding would have a balance of $5,255.81 after the same time.
The takeaway here is that your compounding frequency matters. A more frequent compounding equals greater earning potential for you. If you’re trying to evaluate two different accounts with different compounding interest rates, it’s a good idea to crunch the numbers and make sure you understand what will happen to your money. A lower interest rate with frequent compounding may earn you more than an account with a higher interest rate that’s compounded less frequently.
Compound Interest and Borrowing
So far, we’ve focused on compound and simple interest as they relate to savings, but what about the interest you pay when you borrow money to buy a house or a car?
In most cases, lenders do use compounding interest when they loan money to people. If you know anything about mortgage amortization, you know that in the early years after you buy a home, your monthly payments are skewed heavily toward interest. However, you’re still accruing interest on the remaining balance and that interest compounds. As you get further into your mortgage term, you’ll gradually start paying more toward the principal sum than the interest until your loan balance is fully paid.
In a borrowing situation, compounding interest adds to your loan balance. Some mortgage lenders compound interest daily. If you look at the previous section, you should be able to see how the compounding interest can add up over time.
The good news is that you can do some things to reduce the amount of interest you’ll pay over the term of your mortgage. Here are some examples:
- If you can afford the monthly payments, you can opt for a shorter mortgage term of 15 or 20 years instead of the traditional 30 years.
- If your lender will allow it, you pay extra money toward the principal of your loan each month. Reducing the principal will also reduce the amount of interest you pay.
- Make an extra mortgage payment when you have the money to do so. Making 13 payments a year instead of 12 can help you pay your mortgage off more quickly.
In each case, you’ll save some money on interest over the term of your mortgage. If you get paid every other week, then making a 13th mortgage payment may be relatively easy because you’ll get two “extra” paychecks each year and you can put those toward your mortgage. Even paying a little extra each month can make a difference.
You should be aware that the same strategies we’ve listed above may be used to reduce the interest you pay on an auto loan or any other loan. You’ll need to check with your lender to make sure that you can make extra payments toward the principal, but if they say yes, then it’s a good idea to do that when you can.
Which is Better, Compound Interest or Simple Interest?
Both simple interest and compound interest have their advantages and disadvantages. With simple interest, the interest calculation is easy to do and you can figure out easily how much interest you’ll earn (or pay) in a given period of time. Calculating compound interest requires more complex math.
When it comes to saving money, it is clear that compound interest is preferable because it enables you to grow your savings far more quickly than you could with simple interest. In many cases, financial institutions compound interest for money market accounts monthly, and that means there’s a big difference in what you can earn when you compare a savings account and a money market account.
The downside of a money market account (and some other investments that offer compounding interest) is that you may not have the same access to your money, with limitations on monthly transactions and minimum balances. You may also be required to pay higher fees than you would with a savings account. You’ll need to balance these things before you decide if a money market account is right for you.
In terms of borrowing, in most cases you will be required to pay compound interest. However, if you can borrow money with a simple interest rate you can save a lot of money. For example, if you borrowed $10,000 from a family member and agreed on a simple 5% interest rate, you would repay $10,500. If you borrowed the same amount from a lender with the same interest rate and a two year term, you would pay $10,530.22 assuming daily compounding.
The bottom line is that if your goal is to save, a compound interest rate is preferable to a simple interest rate because it allows you to put your money to work for you and accrue savings as quickly as possible.
Understanding the key differences between simple and compound interest can help you make the most of the money you save. It can also help you to minimize the amount of interest you pay when you buy a house or a car.
Do you want to reap the benefits of compound interest for your savings? Click here to open an Addition Financial Insured Money Market Account now.
Posted on Aug 9, 2021
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