Understanding interest is crucial when investing your money. Given the option to earn simple or compound interest, you should always choose the latter. To understand compound interest, you first need to have a good understanding of simple interest. Here at First United Bank & Trust, we strive to make wealth management as easy as possible, so we’ve put together a helpful guide that clearly outlines how compound interest works.
What Is Simple Interest?
Simple interest [3] is just as the term implies — very simple to calculate. Let’s say you’re investing $12,000 at 7% simple interest. After the first year, seven percent of the original investment amount is added to your account, which means you earn $840 in interest. This same amount is then added every 12 months. So, after five years, you will have earned $4,200 in interest, which brings your total account value to $16,200. It’s important to note that the 7% simple interest rate is always added only to the original investment amount.
What Is Compound Interest?
With compound interest, the interest is added to the new account balance each year. So, for a $12,000 investment with 7% compound interest, there is no difference in the amount earned during the first year. You will have earned $840 just as you did with the 7% simple interest. However, during the second year, the 7% interest is calculated according to the new balance of $12,840, meaning you will earn $898.80 in interest, which brings your new account balance to $13,738.80.
During the third year, you earn another seven percent based on the new account balance, so the total interest earned is $961.72, bringing your new account balance to $14,700.52. This compounding interest continues for the life of the loan or as otherwise stated in the loan terms.
Let’s take a look at the difference earned between 7% simple and compounding interest on a $12,000 investment during the first five years. You can perform your own simple and compounding interest calculations by using an online interest rate calculator.
| Year | Simple Interest
7% |
Simple Interest Account Balance | Compound Interest 7% | Compound Interest Account Balance |
| 1 | $840.00 | $12,840 | $840.00 | $12,840.00 |
| 2 | $840.00 | $13,680 | $898.80 | $13,738.80 |
| 3 | $840.00 | $14,520 | $961.72 | $14,700.52 |
| 4 | $840.00 | $15,360 | $1,029.04 | $15,729.55 |
| 5 | $840.00 | $16,200 | $1,101.07 | $16,830.62 |
While it may not look like much of a difference within the first five years, consider the difference in your total account balances if you invest $12,000 for 20 to 30 years with 7% simple or compound interest.
| Year | Simple Interest 7% | Compound Interest 7% |
| 20 | $28,800 | $46,436.21 |
| 23 | $31,320.00 | $56,886.36 |
| 26 | $33,840.00 | $69,688.24 |
| 28 | $35,520.00 | $79,786.06 |
| 30 | $37,200.00 | $91,347.06 |
$12,000 at 7% simple interest will turn into $37,200 after 30 years. The same investment at 7% compound interest will turn into $91,347.06. That’s a significant difference.
The difference becomes even more drastic if you add to your account each month. Over those 30 years, if you add just $100 to the compound interest account each month, your total account balance at the end of 30 years will be $204,700. If you add $100 to the simple interest account, your account balance after 30 years is only $73,100.
Compounding Frequency
In the examples shown above showcasing compounding interest, the interest was compounded annually. When making your investment, though, you can search for options that give you the ability to have more frequent compounding, such as quarterly or monthly.
The more compounding, the better. Take for example you make a $10,000 investment at 8% compound interest. After 10 years, if the interest is compounded annually, your total account balance is $21,589. If it’s compounded monthly, the total account balance becomes $22,196.
The Takeaway
There are lots of ways to invest your money. Investing in a savings account that draws compounding interest, however, is one of the smartest ways to grow your money. It comes with no risk, and you’re guaranteed to walk away with more than what you put in.