Simple Or Compounding Interest – What Makes More Money?

Albert Einstein called compound interest the “Eighth Wonder of the World”. So exactly what is compound interest, how does it work…and what is simple interest? The question then becomes: What makes more money?

Compound interest is where interest paid on an investment is added to your original sum then interest is again calculated on the full amount. Interest is added once again to the total, each time increasing the sum. Thus $1,000 at 5% becomes $1,050 after the first year, in the second year interest of $52.50 is again added becoming $1,102.50 and so on – unlike simple interest where the same amount of interest is paid on the amount each year.

To best explain let’s look at an example (please note for simplicity inflation is not included and the return is tax paid).

Brad and Simon are each given $10,000 by their grandfather. Brad puts his money away in an investment earning 5% while he travels around the world on his OE (overseas experience). Simon decides the interest would be a good source of pocket-money and draws the interest as it is paid. He thinks he’s doing very well because he managed to get a rate of 5.5% which means he’s getting $550 every year.

As Brad is not using the return on the funds his investment is experiencing compound interest. Simon on the other hand is drawing the income from his investment and therefore his experience is of simple interest.

Brad returns after ten years away. His $10,000 has now grown to $16,288.95 (interest $6,288.95). Although Simon was able to get an extra 0.5% he has only received $5,500 in interest and he’s used the money so all he has now is $10,000.

While Simon has achieved a lesser return overall he has had the use of the money but as he’d considered it to be pocket-money he’s unlikely to have put those funds to good use over the ten years. Brad has certainly been wiser with his money and made more.

But beware…just as you can make more money using compound interest so can the bank or credit card company. Yes, that’s right compound interest works just the same on debt. While it makes more money for the bank you end up paying more on your debt.

Except in the first year, where payments are equal (if the frequency of compounding is annual and the interest rate is the same)compound interest is always greater than simple interest. Therefore compound interest makes more money.

Lyn Bell has been in the finance industry for more than 30 years and is a Certified Financial Planner. She has helped many clients achieve their financial goals. Sign up to get Lyn’s free newsletter SoundFinance News and receive a free gift.

Please note this article does not contain specific advice and is for information/education purposes.

A disclosure statement is available free on request.