Compound interest earns more money than simple interest because you earn interest on the interest that has already been added to your balance. Over time, this “interest on interest” effect compounds, causing growth to accelerate rather than proceed in a straight line. Key ideas
- Simple interest: interest is calculated only on the initial principal. The amount of interest earned each period stays the same, so the total grows linearly over time.
- Compound interest: after each period, the earned interest is added to the principal, so the next period’s interest is calculated on a larger balance. This leads to exponential growth over longer horizons.
Why compounding matters most over longer periods
- The difference between the two grows as time passes. Early starting times yield a much larger final amount under compounding, even if the interest rate is the same, because more periods of accumulation occur.
- Higher compounding frequency (monthly, quarterly, daily) increases the effect, since interest is added to the balance more often, creating more “interest on interest” opportunities.
Illustrative intuition
- If you invest the same principal at the same rate for the same term, simple interest grows by a fixed amount each year, while compound interest grows by a larger and larger amount each year as the accumulated interest itself earns interest.
Practical implications
- For savers and investors, choosing accounts that compound interest (and doing so as frequently as possible, within reasonable risk) generally yields higher ending balances over time.
- For borrowers, compound interest can cause debt to grow more quickly if the rate and compounding frequency are unfavorable, so understanding the terms is important.
If you’d like, I can walk through a concrete numerical example with your preferred principal, rate, compounding frequency, and time horizon to show exactly how the totals compare.
