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Simple vs Compound Interest
Simple interest is calculated only on the principal amount, while compound interest is calculated on the principal plus accumulated interest. Compound interest grows faster over time.
Understanding Interest
Simple vs. Compound Interest
Simple interest is calculated only on your original principal — if you deposit $10,000 at 5% simple interest, you earn exactly $500 per year regardless of how long the money stays invested. Compound interest, on the other hand, is calculated on your principal plus all accumulated interest. That same $10,000 at 5% compounded annually grows to $10,500 after year one, $11,025 after year two, and $16,289 after ten years. The difference becomes dramatic over longer periods: after 30 years, simple interest gives you $25,000 while compound interest gives you $43,219.
The Rule of 72
The Rule of 72 is a quick shortcut for estimating how long it takes your money to double. Divide 72 by the annual interest rate: at 6%, your money doubles in about 12 years; at 8%, about 9 years; at 12%, about 6 years. This works well for rates between 4% and 12%. For more precise calculations, use the formula: years to double = ln(2) / ln(1 + rate). The Rule of 72 is useful for quickly comparing investment options or understanding the long-term impact of different rates.
Compounding Frequency Matters
How often interest compounds affects your total return. Daily compounding earns more than monthly, which earns more than quarterly or annually — though the differences narrow at lower rates. A $10,000 deposit at 5% earns $500.00 compounded annually, $511.62 compounded monthly, and $512.67 compounded daily. Most US savings accounts and CDs compound daily. When comparing offers, look at the APY (Annual Percentage Yield), which accounts for compounding frequency, rather than the APR (Annual Percentage Rate), which does not.
Frequently Asked Questions
What is the difference between simple and compound interest?
Simple interest is calculated only on the original principal. Compound interest is calculated on the principal plus accumulated interest, causing your money to grow faster over time. Most savings accounts, CDs, and investments use compound interest.
How does compounding frequency affect returns?
The more frequently interest compounds (daily vs. monthly vs. annually), the more you earn. For example, $10,000 at 5% compounded daily earns slightly more than the same amount compounded annually, because interest starts earning interest sooner.
What is the difference between APR and APY?
APR (Annual Percentage Rate) is the stated interest rate without accounting for compounding. APY (Annual Percentage Yield) includes the effect of compounding and reflects your actual annual return. APY is always equal to or higher than APR.
What is the Rule of 72?
The Rule of 72 is a quick way to estimate how long it takes for an investment to double. Divide 72 by the annual interest rate — for example, at 6% interest, your money doubles in approximately 12 years (72 / 6 = 12). This works best for rates between 4% and 12%.
How much interest will I earn on a savings account?
It depends on your balance, the APY, and compounding frequency. A $10,000 balance at 4.5% APY compounded daily earns approximately $460 in the first year. High-yield savings accounts from online banks typically offer the best rates, often 10–20 times higher than traditional brick-and-mortar banks.