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Simple interest vs compound interest: Understanding the difference

Simple interest vs compound interest: Understanding the difference

20 Dec, 2022 - 4 min read

Putting a part of your income into savings is often a smart financial habit to get into. When you make deposits into your savings, you want your money to grow by earning interest. You can build up your savings to put into an investment portfolio, buy a house, have an emergency fund, or fund other major purchases.

When it comes to the interest you earn on a savings account, you may have heard that it’s either simple or compound interest. But what is the difference between these two types of interest, and which one will work more effectively to grow your wealth?

Disclaimer

This article is over two years old, last updated on December 20, 2022. While RateCity makes best efforts to update every important article regularly, the information in this piece may not be as relevant as it once was. Alternatively, please consider checking recent savings accounts articles.

What is simple interest?

Simple interest is a type of interest that is occasionally used by savings accounts to earn interest and help your money grow. It works by giving you a fixed interest payment over a set period, depending on what you choose.

For example, if you invest $10,000 at 3 per cent for five years, you would receive $300 in interest per year and $1,500 in interest at the end of 5 years. It means your savings will grow to $11,500 at the end of 5 years.

This interest type is most commonly used with some term deposits or some types of loans as long as you continue payments.

What is compound interest?

Another type of interest used with savings accounts is compound interest. When you earn compound interest, you earn interest on top of any interest you've already earned on your savings. This means you earn interest; it’s paid and added to your savings, and it’s included in the subsequent calculation to earn interest; hence it’s compounded. This is how most Australian savings accounts and term deposits earn interest.

Instead of waiting for interest to be paid at the end of a period, you have it calculated and paid incrementally. Depending on your account, these increments can be quarterly, monthly, weekly, or even daily. As the interest payments compound, your savings will rise even quicker.

For example, imagine you have $10,000 invested at 3 per cent per year and choose to have the interest paid monthly. You’ll have earned $1,661 in interest over five years - an extra $161 compared to an account with simple interest. And this is without having a regular savings plan that would increase your investment amount.

This is where compound interest can significantly affect how you grow your wealth.

Simple interest vs compound interest, what’s the difference?

The main difference between simple and compound interest is the principal amount on which the interest is calculated. It’s straightforward to calculate how much interest you’ll earn in an account that pays you simple interest. However, it’s less immediately clear how much you'll get with compound interest, as it depends on the money in the account at the time and the interest rate.

Simple interest is always calculated on the original amount of the deposit or loan. Thus, the amount on which simple interest is calculated remains the same for the loan or deposit term duration. However, compound interest pays interest on interest. It means the principal amount for calculating interest changes continuously - it’s the sum of the principal amount and the interest it accumulates in every period.

For example, if the interest is paid monthly, the principal amount for the second month would be the sum of the principal amount for the first month and the interest earned on it, and so on. Due to this, compound interest is generally believed to grow your savings faster.

Compound interest can be earnt daily, weekly, monthly, yearly and sometimes at other intervals, whereas simple interest is only earnt for a specific period you set when you open the account. Therefore, saving your money in a high interest savings account that pays compound interest could help you grow your savings faster. However, ensure you read the product disclosure statement carefully before opening an account. There may be fees or restrictions on withdrawing your money that could reduce the amount of interest you earn on your savings.

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Product database updated 21 Dec, 2024

This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.

Jodie Humphries

Personal Finance Editor

Jodie Humphries is an experienced Personal & Home Finances Editor with expertise in financial topics, including credit, loans, superannuation, mortgage and housing, insurance, telecommunications, and more. For over a decade, Jodie's journalism and editing career has seen work published at both Finder and Sharesight. As one of RateCity's chief contributors, Jodie spent her time working on ways to make personal finances within reach of everyone in Australia.