Simple vs compound interest: the difference, in numbers

The difference, in one sentence

With simple interest, interest is always calculated on the starting capital. With compound interest, it is added to the capital and starts earning interest itself.

Put that way it sounds like a nuance. With numbers it stops sounding like one.

The same inputs, two outcomes

Take €10,000 at 4% a year and let it run:

Over five years the gap is almost anecdotal. Over thirty, compounding has produced more than ten thousand euros extra without you contributing another cent.

The reason is that under simple interest each year produces the same €400, while under compounding year thirty earns interest on a balance already near €31,000.

Where each one appears

Simple interest, in Spanish practice:

• very short-term arrangements
• some loans between individuals
• commercial discounting of bills
• certain late-payment interest and surcharges, calculated on the amount owed without compounding

Compound interest:

• deposits that capitalise interest
• pension plans
• accumulating funds and ETFs, which automatically reinvest their income
• and credit-card debt, where it works against you

Who each one suits

For the investor, compounding always gives the same or more. There is no scenario where simple interest is preferable: the only way they tie is a term of a single period.

For the borrower, it is exactly the reverse. Interest on a debt that does not compound works in your favour. It is why unpaid card debt grows so fast: it is not only the high rate, it is that the rate applies to a balance which already includes last month's interest.

When comparing two offers, look at the compounding

4% says nothing on its own. 4% simple and 4% compound are different products, and 4% compounded monthly returns slightly more than 4% compounded annually.

Before comparing two percentages, check whether they compound and how often. It is always in the product documentation, and without it the comparison means nothing.