Simple versus compound interest: the difference, with numbers

The difference, in one sentence

With simple interest, the interest is always calculated on the starting capital. With compound interest, the interest is added to the capital and from then on earns interest itself.

Everything else follows from that sentence.

The same figures, two results

€10,000 at 5% a year, no extra contributions, annual compounding in the compound case:

After one year there is no difference: the interest has not yet had time to earn anything. After five years the gap is a few points. After thirty years compound interest yields almost twice as much, and most of that difference arrives in the last ten years. The simple interest calculator shows both columns with your own numbers.

Where each one appears

Simple interest:

• statutory and default interest: in Italy, overdue interest does not earn interest, except by court claim or an agreement made after it fell due, and article 1283 of the Civil Code says so
• many private loans and short payment deferrals
• trade discounts and operations lasting a few months

Compound interest:

• deposit accounts that compound interest (net of the 26% withholding)
• mutual funds and ETFs, especially accumulating ones, which reinvest their income
• pension funds and savings plans
• unpaid debts that earn interest on interest, within the limits of the law: revolving cards and overdrafts, where high rates do the rest

Who each one suits

For a saver, compound interest is always better: it yields the same or more, never less. For a payer, simple interest is better: if you owe money, interest that does not compound works in your favour, which is why Italian law limits interest on interest.

When you compare two offers, look at the compounding

4% compounded monthly yields more than 4% simple, and more than 4% compounded once a year. The headline number in an offer is often the nominal rate; what counts is the effective rate, which depends on how many times a year interest is credited and, for a deposit account, on when the bank withholds the tax. The guide what is compound interest shows what each frequency is worth and how taxation changes the curve.