While you may not see a loan that compounds like this in real life, this example is helpful to illustrate the difference. In the U. While in general, compound interest refers to investments and simple interest refers to loans, there are exceptions to this.
Knowing how the interest works could save you — or make you — a lot of money. Review how to grow your savings and make wise investments using the power of interest.
Andrew Dehan is a professional writer who writes about real estate and homeownership. He is also a published poet, musician and nature-lover. He lives in metro Detroit with his wife, daughter and dogs. Personal Finances 6-minute read Scott Steinberg April 23, Looking to open a savings account?
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The amount of simple interest paid is:. Compound interest accrues and is added to the accumulated interest of previous periods; it includes interest on interest, in other words. The formula for compound interest is:. It is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods, and then minus the reduction in the principal for that year.
With compound interest, borrowers must pay interest on the interest as well as the principal. Below are some examples of simple and compound interest. Continuing with the above example, suppose your certificate of deposit is cashable at any time, with interest payable to you on a prorated basis.
If you cash the CD after four months, how much would you earn in interest? How much would Bob have to pay in interest charges every year, and what would his total interest charges be after three years?
Assume the principal amount remains the same throughout the three years, i. Unfortunately, his rich uncle is tapped out. What would be the total interest paid by Bob? Since compound interest is calculated on the principal and accumulated interest, here's how it adds up:.
It can also be determined using the compound interest formula from above:. This example shows how the formula for compound interest arises from paying interest on interest as well as principal.
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