Simple interest and compound interest both describe how money grows over time — but they work very differently, and the gap between them widens dramatically over long periods. Understanding which applies to any given account or loan changes how you interpret the rate you're being quoted.
How simple interest works
Simple interest is calculated on the original principal only, every period. The formula: Interest = Principal x Rate x Time. A $5,000 loan at 6% simple interest for 3 years generates $900 in interest regardless of when payments are made. The balance does not grow on itself — interest is always a flat percentage of the starting amount.
Simple interest is common in: auto loans, some personal loans, short-term business loans, and bonds. It is straightforward to calculate and favors borrowers over compound interest at the same stated rate.
How compound interest works
Compound interest is calculated on the principal plus any interest already earned. Each period, the balance grows — and next period's interest is calculated on that larger balance. This is what people mean when they talk about "interest on interest." The formula: A = P(1 + r/n)^(nt), where n is the number of compounding periods per year.
Compound interest is used in: savings accounts, CDs, mortgages, credit cards, investment accounts, and most retirement accounts. For savers and investors, it is the mechanism behind long-term wealth building. For borrowers carrying high-rate balances, it is the mechanism behind debt that seems difficult to eliminate.
The real difference over time
On short timelines, simple and compound interest produce similar results. The divergence grows with time. Consider $10,000 at 7% for 30 years: simple interest produces $31,000 in growth. Compound interest produces about $66,000 in growth — more than twice as much. The difference is entirely due to the compounding effect: each year's interest earns its own interest in subsequent years.
Credit cards: compound interest working against you
Credit cards use daily compound interest on carried balances. The daily periodic rate is the APR divided by 365. On a $3,000 balance at 24% APR, daily interest is about $1.97 — roughly $60/month. If you pay only the minimum, the balance barely moves because most of each payment goes to interest, and the remaining balance continues compounding.
Divide 72 by the annual compound interest rate to get the approximate number of years it takes to double your money. At 6%, money doubles in about 12 years. At 8%, about 9 years. At 4%, about 18 years.
Frequently asked questions
Do savings accounts use simple or compound interest?
Virtually all savings accounts, money market accounts, and CDs use compound interest. The APY they advertise already reflects compounding — it is always higher than the stated rate for this reason.
Which type of interest does a mortgage use?
Mortgages use compound interest in their amortization calculation, but are structured as fixed monthly payments. Each payment covers that month's interest first, then reduces principal. Because interest is recalculated on the declining balance each month, early payments are heavily interest-weighted and later payments shift toward principal.
Good places to double-check
Look at the interest method, compounding frequency, rate, and timeline. For credit cards, savings accounts, CDs, and loans, the product terms tell you how interest is calculated.