Home > Personal Finance > Simple vs. Compounding Interest: How Does It Work?

Comments 0 Comments

You may think of interest as a negative – when you have to pay it for taking out a loan or borrowing money with a credit card. But when you start to consider your retirement savings and investment strategies, you will realize that not all interest is bad. And not all interest is created equal. The guide below can help you understand the simple distinction between interest and compounding interest – and how that one added word could have a big effect on your financial health.

The Basics

Interest is the cost associated with borrowing money. You may pay interest to a lender for a mortgage, auto loan or credit card. Interest is typically stated as a percentage of the principal amount. Any party that borrows money typically makes interest payments on top of the agreed upon loan amount.

Consider the rate on your credit card, student loans, or mortgage as examples. High rates can become very costly very quickly, so when you are borrowing, you generally want to look for low interest-rate loans. (A good credit score helps you qualify for lower rates, so it’s a good idea to check your credit before you apply with a lender. You can pull your credit reports for free each year at AnnualCredit Report.com and see your credit scores for free each month on Credit.com.)

But, as I mentioned earlier, you can also earn interest. This is the money you earn just for keeping your money somewhere without touching it. For instance, a financial institution may pay interest on a certificate of deposit, retirement fund or simple savings account. In that case, when you are earning, generally the higher the interest rate, the better.

Simple vs. Compounding Interest

Interest can be either simple or compounded. Simple interest is determined solely on the original principal. Generally, this is a fixed rate. The formula for simple interest is the principal amount multiplied by the interest rate (by the term of the loan, if you are borrowing).

On the other hand, compound interest changes every period. Calculated by multiplying the interest rate by the principal amount plus the accumulated interest of previous periods, compound interest is often referred to as “interest on interest.”

What Does this Difference Mean for Me?

The best way to put this knowledge of the different types of interest to use is investing regularly in vehicles that feature compounding interest and taking loans out with only simple interest. Compounding interest is sometimes referred to as letting your money make money. It’s a way to increase how much money you have earning more money. It’s one of the reasons why it’s so important to begin saving for retirement early – you give your money more time to work for you.

Understanding the basic financial concepts of simple and compounding interest will give you a better idea of how to use your money and credit. It’s important to read all the fine print and be completely clear on the terms either when you are taking out a loan or making an investment.

More Money-Saving Reads:

Image: iStock

Comments on articles and responses to those comments are not provided or commissioned by a bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by a bank advertiser. It is not a bank advertiser's responsibility to ensure all posts and/or questions are answered.

Please note that our comments are moderated, so it may take a little time before you see them on the page. Thanks for your patience.

Credit.com receives compensation for the financial products and services advertised on this site if our users apply for and sign up for any of them.

Hello, Reader!

Thanks for checking out Credit.com. We hope you find the site and the journalism we produce useful. We wanted to take some time to tell you a bit about ourselves.

Our People

The Credit.com editorial team is staffed by a team of editors and reporters, each with many years of financial reporting experience. We’ve worked for places like the New York Times, American Banker, Frontline, TheStreet.com, Business Insider, ABC News, NBC News, CNBC and many others. We also employ a few freelancers and more than 50 contributors (these are typically subject matter experts from the worlds of finance, academia, politics, business and elsewhere).

Our Reporting

We take great pains to ensure that the articles, video and graphics you see on Credit.com are thoroughly reported and fact-checked. Each story is read by two separate editors, and we adhere to the highest editorial standards. We’re not perfect, however, and if you see something that you think is wrong, please email us at editorial team [at] credit [dot] com,

The Credit.com editorial team is committed to providing our readers and viewers with sound, well-reported and understandable information designed to inform and empower. We won’t tell you what to do. We will, however, do our best to explain the consequences of various actions, thereby arming you with the information you need to make decisions that are in your best interests. We also write about things relating to money and finance we think are interesting and want to share.

In addition to appearing on Credit.com, our articles are syndicated to dozens of other news sites. We have more than 100 partners, including MSN, ABC News, CBS News, Yahoo, Marketwatch, Scripps, Money Magazine and many others. This network operates similarly to the Associated Press or Reuters, except we focus almost exclusively on issues relating to personal finance. These are not advertorial or paid placements, rather we provide these articles to our partners in most cases for free. These relationships create more awareness of Credit.com in general and they result in more traffic to us as well.

Our Business Model

Credit.com’s journalism is largely supported by an e-commerce business model. Rather than rely on revenue from display ad impressions, Credit.com maintains a financial marketplace separate from its editorial pages. When someone navigates to those pages, and applies for a credit card, for example, Credit.com will get paid what is essentially a finder’s fee if that person ends up getting the card. That doesn’t mean, however, that our editorial decisions are informed by the products available in our marketplace. The editorial team chooses what to write about and how to write about it independently of the decisions and priorities of the business side of the company. In fact, we maintain a strict and important firewall between the editorial and business departments. Our mission as journalists is to serve the reader, not the advertiser. In that sense, we are no different from any other news organization that is supported by ad revenue.

Visitors to Credit.com are also able to register for a free Credit.com account, which gives them access to a tool called The Credit Report Card. This tool provides users with two free credit scores and a breakdown of the information in their Experian credit report, updated twice monthly. Again, this tool is entirely free, and we mention that frequently in our articles, because we think that it’s a good thing for users to have access to data like this. Separate from its educational value, there is also a business angle to the Credit Report Card. Registered users can be matched with products and services for which they are most likely to qualify. In other words, if you register and you find that your credit is less than stellar, Credit.com won’t recommend a high-end platinum credit card that requires an excellent credit score You’d likely get rejected, and that’s no good for you or Credit.com. You’d be no closer to getting a product you need, there’d be a wasted inquiry on your credit report, and Credit.com wouldn’t get paid. These are essentially what are commonly referred to as "targeted ads" in the world of the Internet. Despite all of this, however, even if you never apply for any product, the Credit Report Card will remain free, and none of this will impact how the editorial team reports on credit and credit scores.

Your Stories

Lastly, much of what we do is informed by our own experiences as well as the experiences of our readers. We want to tell your stories if you’re interested in sharing them. Please email us at story ideas [at] credit [dot] com with ideas or visit us on Facebook or Twitter.

Thanks for stopping by.

- The Credit.com Editorial Team