Banking 101: Simple and Compound Interest Explained

Banking terminology can sometimes feel confusing, especially when it comes to interest. Interest is what a financial institution may pay when you deposit money in a checking or savings account or a certificate of deposit (CD), and what you pay to a lender when borrowing money or using a credit card. Interest rate is usually shown in ads and marketing materials as a percentage, such as 5.00%, and as a decimal, such as .05, when used in calculations.

There are two interest calculations commonly used in banking – simple interest and compound interest. Whether you are depositing money or borrowing, make sure to read your account agreement to understand how the interest will be computed on your balance and how often.

Simple Interest

With simple interest, the interest is paid only on the original balance, which is also called the principal. Simple interest is calculated by multiplying the stated interest rate by the principal by the number of years.

For example, for a $1,000 savings account balance with a simple interest rate of 5.00% to be paid annually for five years and left untouched for the deposit period, the simple interest calculation is:

                $1,000.00 x .05 x 5 = $250.00

Here is the interest broken out by year:

               Year 1: $1,000.00 x .05 = $50.00 interest 

               Year 2:  $1,000.00 x .05 = $50.00 interest

               Year 3:  $1,000.00 x .05 = $50.00 interest

               Year 4: $1,000.00 x .05 = $50.00 interest

               Year 5:  $1,000.00 x .05 = $50.00 interest

               Total interest over five years = $250.00

In a savings scenario, simple interest will pay the depositor less in total interest than compound interest, because the interest payment is calculated on only the original principal.

When borrowing money with simple interest, as the principal is paid off, the interest is calculated on the smaller principal amount due. Car loans and most traditional mortgages are based on simple interest.

Simple interest loans are typically repaid in equal, monthly installments. Part of each payment goes to payment of calculated interest due for the month and the rest is applied to pay down the loan’s principal balance. At the beginning of the loan, more of the monthly payment goes towards the interest. As the principal balance is paid down with each payment over the term of the loan, more of the payment applies to the principal with each monthly payment.

Compound Interest

Compound interest is slightly more involved when it comes to calculating the amount of interest earned or paid. With compound interest, the interest earns interest. Each new interest payment is calculated on the original principal plus any accumulated interest. A deposit account with compound interest would receive more in total interest than one with simple interest over the same length of time. Compound interest is compounded daily, monthly, or annually, and the frequency is stated in the account agreement.

For example, for a $1,000 savings account balance with a compound interest rate of 5.00% to be paid annually for five years and left untouched for the deposit period, the increase in principal and the new interest for each year is:

                Year 1:  $1,000.00 x .05 = $50.00 interest

                Year 2:  $1,050.00 x .05 = $52.50 interest

                Year 3:  $1,102.50 x .05 = $55.125 Interest

                Year 4:  $1,157.625 x .05 = $57.881 interest

                Year 5:  $1,215.506 x .05 = $60.775 interest

                Total interest over five years = $276.281

For a loan with compound interest, such as most credit cards, interest is added to the amount owed and you pay interest on top of interest. The longer the loan balance sits unpaid, the more interest that accrues. If you keep a balance on a credit card, interest charges are added to the principal which increases the debt exponentially over time.

There are online calculators available that can help you to calculate interest.