What is the difference between simple and compound interest?

If you understand the difference between simple and compound interest, it can help you make (and/or save) a great deal of money. First let’s define our terms and then we’ll put the concepts to work.

What is simple interest?

Simple interest is a fixed amount charged on a fixed loan amount for the life of the loan. Let’s say you borrow $10,000 from your kindly Uncle Ned for one year. He has agreed to charge you 5% simple interest. So the interest you will pay is $500 for that year. That is the fixed amount Ned is charging you. If you make no payments during the year, you will repay Ned $10,500 after 12 months. This includes the principal and the simple interest. See….simple.

In many cases simple interest loans are also interest only loans. That means if you make payments they are only for the interest. So if you divide up the $500 in interest that Ned wants over 12 months, you will pay $41.67 each month. Then at the end of the year you will return the $10,000 to Ned as a balloon payment. The total repayments are still $10,500. That is a simple interest loan with interest only payments. Easy as pie.

What is compound interest?

Compound interest is when the interest amount you owe or pay changes as the balance you owe changes. This is the way amortization works. The best way to understand this is also by way of example. Let’s say Ned loans you the $10,000 at 5% compound interest. Let’s also assume that you don’t make any payments during the year. Look at the chart below.

At the end of the first month you still owe $10,000 but you also owe $41.67 in interest. At the end of the second month, you owe $10,041.67 plus interest on $10,041.67. You calculate that interest as follows:

1/12 x 5% x $10,041.67

The interest you owe at the end of the second month is $41.84 – a slight increase. You owe more interest because your debt is slightly larger. It’s the principal plus the interest. This is an example of compounding.

You can see that the interest amount you owe rises each month because your balance grows. And as your balance grows, the interest amount grows faster and faster. Compound interest is what Albert Einstein referred to as the 8th wonder of the world and for good reason. If you compare, you can see that with simple interest, you paid a total of $500 to Ned. With compounded interest, you paid $511.62.

It may not seem like a big difference but given enough time and money, you can use the concept of compound interest to create wealth.

How do you use the difference between compound and simple interest to build wealth?

If you want to use your new-found understanding of simple and compound interest to make money, it boils down to this. When you borrow money, try to make sure you do so using simple interest. When you loan out money, make sure it’s compounding.

One of my all-time favorite financial gurus Vito Corleone (aka the Godfather) illustrated the power of this concept par excellence. He took simple interest and combined it with an amortized loan rather than an interest only loan. Here’s how it worked:

When people came to the Don needing cash he was only too happy to help out – but he took his interest first. This was genius.
So when some poor soul borrowed $100 from the Godfather, the Don took his $10 interest up front. Was the borrower paying 10%? No…he was paying much more. That’s because the borrower only got $90 but he was paying $10 interest. Now that pisan is actually paying 11%. It couldn’t be helped. It was an offer he couldn’t refuse.

But it gets better – for Don Corleone. Much better.

What happens if the borrower repays the loan in 10 months at $10 per month? What happens is the Godfather becomes very wealthy. This is how Vito put the Corleone family on the map.

The borrower was repaying $9 principal every month and $1 interest. Capishe? The borrower continues to pay the $1 interest every month even though the debt he owes the Godfather gets smaller and smaller. Take a look at this chart to see how outrageous the interest rate is:

You can see that the average interest rate the borrower pays the Godfather in this example is an amazing 37%.
While I hope you don’t need to borrow money from the Godfather, it still helps to see how important it is to:

1. Borrow money as infrequently as you can.
2. Try to get a simple interest loan.
3. Never pay interest up front.
4. If you make a loan to someone, make sure it is a compounding loan.

How are using the ideas of simple and compound interest to save money?