Simple vs. Compound Interest: What Every Investor and Borrower Should Know

The Power of Interest: Friend or Foe?

When it comes to money, “interest” is always in the picture. Sometimes it works for you, sometimes it works against you. Albert Einstein is often quoted as saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Whether he truly said it or not, the idea rings true—interest can be either a steppingstone to building wealth or a stumbling block to debt.

But not all interest is created equal. Let’s break it down into two main types: simple interest and compound interest.

Simple Interest: The Straightforward Path

Think of simple interest like a flat road—predictable, steady, and without any surprises. It’s calculated only on your original amount (the principal).

For example:

You invest $50,000 at 10%. Each year, you earn $5,000.

·  Year 1: $50,000 + $5,000 = $55,000

·  Year 5: $50,000 + ($5,000 × 5) = $75,000

·  Year 10: $50,000 + ($5,000 × 10) = $100,000

·  Year 30: $50,000 + ($5,000 × 30) = $200,000

No extra each year—just the same $5,000 year after year.

* This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing

This can be great when you’re the one borrowing money, because you’re not paying interest on top of interest. The debt can be easier to manage and pay off.

Compound Interest: The Snowball Effect

Now imagine rolling a snowball down a hill. At first, it’s small. But as it rolls, it gathers more snow and grows larger—and the bigger it gets, the faster it builds. That’s compound interest.

With compound interest, you earn interest on both your original investment and the interest that piles up along the way.

Here’s the same $50,000 at 10%/year with compounding interest.

·  Year 1: $50,000 → earns $5,000 → total = $55,000

·  Year 5: total grows to about $80,525

·  Year 10: total grows to about $129,687

·  Year 30: total grows to about $872,470

See the difference? Each year, the snowball grows bigger because the interest itself is now earning interest.

This is the essence of the “time value of money”—the longer you let your money roll, the more momentum it builds for you.

*This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing

Why Time Matters So Much

The secret ingredient in compound interest is time. The earlier you start, the more years your money has to grow on itself. Starting in your 20s, even with smaller contributions, can often put you ahead of someone who waits until their 40s to begin investing larger amounts. It’s like planting a tree—sooner is better, because growth takes time.

Which Type Benefits You?

• Borrowers often prefer simple interest because it keeps repayment manageable.

• Investors tend to favor compound interest because of its growth potential over time.

The type of interest that benefits you depends on which side of the financial table you’re sitting.

Where Compound Interest Shows Up in Real Life

So, how do you actually put compound interest to work? It shows up in more places than you might expect:

• Money Market Accounts – These involve very short-term debt products. You can access them through a bank account, Treasury bills, or mutual funds. They’re generally low risk, often considered similar to cash holdings.

• Bonds – Essentially an IOU. You lend money to a company or government, and they use your money and will pay you interest until the bond “matures.”

• Certificates of Deposit (CDs/GICs) – You deposit money with an place for a set time (months to years) and earn a fixed interest rate in return.

• Stock investments (Mutual Funds, Exchange-Traded Funds (ETFs), Index Funds) – Investment funds that trade like stocks. They can track an index, sector, or asset class and provide long-term growth potential.

• Dividends & DRIPs – Many companies pay out part of their profits to shareholders. You can take the cash or reinvest it into more shares through a Dividend Reinvestment Plan (DRIP), creating a snowball effect of its own. (Just keep in mind that reinvested dividends can still be taxable even when reinvested)

And beyond these, compound interest can work through real estate investments or even in the growth of a business you build.

The Bottom Line

Simple interest adds up at a fixed pace, like stacking one brick at a time. Compound interest, though, builds on itself—each layer boosting the next. It’s the difference between adding and multiplying. The earlier you begin, the more time your financial snowball has time to grow, potentially turning small beginnings into something substantial.

Disclosures:

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. Stock investing includes risks, including fluctuating prices and loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective. ​ ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.​ Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.​