Compound interest earns interest on both your original deposit and on the interest that has already accumulated. Simple interest only ever earns interest on the original deposit. Over a single year the gap is small. Over thirty years it is the difference between £21,000 and £66,000 of growth on the same starting balance — an unmistakable case for picking the right account type early.
The two formulas, side by side
Simple interest is the straightforward calculation most people meet first. You multiply the principal by the rate and by the number of years — that is your total interest, no matter how long you leave the money invested.
Simple interest: I = P × r × t
Compound interest: A = P (1 + r/n)^(nt)
In the compound formula, n is the number of compounding periods per year and A is the final amount including the principal. The crucial mechanic is the exponent: as t grows, the multiplier grows non-linearly. That is the “snowball” effect you have probably heard about.
A worked example: £10,000 at 7% for 30 years
| Interest type | Interest earned | Final balance |
|---|---|---|
| Simple interest | £21,000 | £31,000 |
| Compound (annual) | £66,123 | £76,123 |
| Compound (monthly) | £71,303 | £81,303 |
| Compound (daily) | £71,705 | £81,705 |
Even at moderate rates, compounding produces roughly three times the interest of simple interest over thirty years. The jump from yearly to monthly compounding adds about £5,000; the jump from monthly to daily adds only another £400. The interest rate and the length of time invested matter far more than the compounding frequency.
Run your own numbers
Try this scenario
Set the principal to 10,000, the annual rate to 7%, the term to 30 years, and toggle the compounding frequency between yearly, monthly, and daily to see the numbers from the table above for yourself.
When is simple interest still used?
Most savings and investment accounts use compound interest. Simple interest still shows up in a few places, almost always for borrowers rather than savers:
- Short-term consumer loans — some car loans and personal loans charge simple interest on the outstanding balance.
- Some mortgages — a small subset of mortgages, particularly in the US, use a daily simple-interest method.
- Promissory notes and seller financing — private loans often default to simple-interest accrual.
- Treasury bills — short-duration government debt is typically quoted on a simple-interest basis.
As a borrower, simple interest is almost always in your favour because the lender cannot charge interest on accrued but unpaid interest. As a saver, compound interest is what you want.
The takeaway
When you are saving or investing for a goal that is more than a few years away — a house deposit, a retirement pot, your children’s university fund — pick an account that compounds. The compounding frequency matters a little; the rate and the time matter enormously. Start as early as you can, contribute regularly, and let the formula do the work.
Frequently asked questions
Is compound interest always better than simple interest?
When you are saving or investing, yes — compound interest grows your balance faster because each period's interest is added to the principal and itself earns interest. When you are borrowing, simple interest is better for you because the lender does not charge interest on accrued interest.
Do banks use simple or compound interest?
Savings accounts, certificates of deposit, and most investment accounts use compound interest, usually compounding daily or monthly. Some short-term consumer loans, car loans, and certain mortgages use simple interest, where interest accrues only on the unpaid principal.
How much difference does compounding really make?
Over short periods of a year or two the difference is small, but it grows dramatically with time. On £10,000 at 7% for 30 years, simple interest yields £21,000 in interest, while annual compounding yields about £66,000 — more than three times as much.
Does compounding frequency matter — daily vs monthly vs yearly?
Yes, but less than most people think. Daily compounding produces only slightly higher returns than monthly, which in turn beats yearly. The interest rate and the length of time invested matter far more than the compounding frequency.
Is the Rule of 72 based on simple or compound interest?
The Rule of 72 is a quick mental shortcut for compound interest. Dividing 72 by the annual return gives you the approximate number of years it takes to double your money. It is accurate for rates between roughly 6% and 10% and assumes annual compounding.