Difference between Simple Interest and Compound Interest

When it comes to investing or saving, it is essential to understand how interest works. It is a term we are familiar with when talking about loans or banking products, but do you know how it can impact your investments?

When focusing on interest, we must first understand that there are two main types: simple interest and compound interest. While both terms refer to the cost of borrowing money or the profit from saving or investing, their differences significantly influence financial outcomes.

To help you make the most of your investment, we have prepared this comprehensive guide for you. Here we will not only define what simple and compound interest are but also explain their differences and how each can impact your finances.

What is Simple Interest?

Simple interest is the type of interest calculated only on the initial principal, the capital invested at the beginning. In this case, the potential reinvestment of interest accumulated over time, which would generate more money, is not considered.

This is a basic interest calculation formula that does not take long-term investment growth into account. The formula for calculating simple interest is as follows:

Simple interest = P x R x T

• P - Initial principal
  
• R - Annual interest rate
  
• T - Time (years the interest is paid)
  

This type of interest is common in bank loans or short-term investments.

Example:

Imagine a bank customer deposits €10,000 in a savings account, which offers a 5% simple annual interest for the next 3 years. The calculation would be as follows:

Simple interest = €10,000 x 0.05 x 3 = €1,500

This means that at the end of 3 years, the customer would earn €1,500 in interest, bringing the total to €11,500 in the savings account.

What is Compound Interest?

Compound interest is a more advanced way of calculating interest. It is applied not only to the initial principal but also to the interest that accumulates over time. In other words, it’s “interest on interest.”

This type of interest is appealing because it allows the value of an investment to grow exponentially over time. The formula for compound interest is as follows:

Compound interest = P x (1 + R) ^ T

• P - Initial principal
  
• R - Annual interest rate
  
• T - Time (years the interest is paid)
  

As time passes, the interest earned is reinvested, increasing the capital on which future interest is calculated.

Example:

Let’s use the same example where a customer deposits €10,000 with a 5% compound annual interest for 3 years. The calculation would be:

Compound interest = €10,000 x (1 + 0.05) ^ 3 = €11,576.25

As you can see, in this case, after 3 years, the customer would have earned €1,576.25 in interest, resulting in a higher return than simple interest, with a total of €11,576.25.

Differences between Simple and Compound Interest

After learning the key characteristics of both types of interest, it’s time to delve deeper into their differences. Which type of interest should you focus on when making an investment?

• Simple interest is only applied to the initial principal.
  
• Compound interest also applies to the interest generated.
  

With this in mind, it’s clear that over the long term, compound interest generates significantly higher returns. The longer the investment or loan duration, the greater the difference between the two types of interest.

When to Choose Simple Interest and When to Choose Compound Interest?

When making an investment, it’s extremely important to know which type of interest to choose to maximize your return.

• Simple Interest - This is an interesting option for short-term investments. Here, the main goal is to receive a predictable and steady income stream, as is the case with certain loans. Example: A customer looking to generate short-term returns with an investment.
  
• Compound Interest - This is appealing for long-term investments where the goal is to maximize capital growth over time. Example: Retirement plans or even long-term investment goals.
  

What Are the Benefits of Compound Interest for Long-Term Investments?

• Interest on interest effect - The longer the investment is allowed to grow, the greater the accumulated benefit. This is known as the “snowball effect,” allowing even small initial investments to grow significantly without the need to add more capital.
  
• Applications in investments and savings - Compound interest is used in long-term financial products such as investment funds, long-term savings accounts, or even in investment products like crowdlending.
  

On platforms like Inversa, you can benefit from compound interest in investment products that offer attractive returns, maximizing your earnings through automatic reinvestments.

Which Option is Better for Your Investments?

The decision between simple and compound interest depends entirely on your financial goals and the timeframe of your investments. If you want to maximize your long-term gains, compound interest is the more attractive option. However, for short-term investments or loans, simple interest is an efficient solution.

If you want to make the most of your investments, the Inversa team will offer investment alternatives where you can benefit from both simple and compound interest, depending entirely on your needs. With flexible and diversified options, you can find the strategy that best suits your financial goals.