Simple Interest vs. Compound Interest
Interest is interest, right? Well actually, no, it isn’t. There’s a big difference between simple and compound interest. Interest is the money you are paid when you put your money into a bank or make another kind of investment. But it’s what you do with that interest that makes the difference between simple and compound interest. If you take your interest and spend it, you are basically earning simple interest. It’s great to have the extra money now, but the total amount of interest over time will be considerably lower than if you were to let the interest compound. Compounding, in essence, means you let the interest earn interest. How much of a difference can this really make? Well, take a look at this chart. It assumes that you put $1000 in the bank today and that your account earns four percent interest annually. You won’t have to put any more money in the bank after today; this chart just shows the work the interest does. The blue line shows what would happen if you took the interest out of your account every year after it had been earned. Every year, your money would earn $40, so after 20 years, you would have earned a total of $800 dollars in interest.
Simple vs. Compound Interest
Total Interest Earned (Dollars)
1400 1200 1000 800 600 400 200 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Years
Blue line = Simple interest; Red line = Compound interest
But look at the red line. That shows how much interest you would earn if you let your interest compound. After 20 years, you would have earned a total of $1191.12. That’s $391.12 more than you could earn with simple interest. Not bad for just letting your money sit around in a bank! Compound interest has an even better effect over time. Say you let your money sit in the bank for another 20 years. After 40 years, your original $1000 would have earned a total of $1600 in simple interest. But by compounding, your $1000 would have increased by $3801.02! That’s more than double what simple interest could have earned!
Simple vs. Compound Interest
4000 Total Interest Earned (Dollars) 3500 3000 2500 2000 1500 1000 500 0 11 13 15 17 19 21 23 25 27 29 31 33 35 37 Years 39 1 3 5 7 9
Simple Interest
Compound Interest
Over time, the effects of compound interest are more dramatic. Look at how much faster compound interest can get you to your financial goals. If you save $1000 a year and let the four percent interest compound, you can have $30,000 saved in less than 20 years. If you were to take the interest out of the bank, it would take you over 10 more years to get to your goal!
70000 60000 50000
Dollars
40000 30000 20000 10000 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Years Total Payments Payments + Compound Interest