Simple vs Compound Interest
The two look similar over a year or two and wildly different over a decade. Simple interest pays you on your principal only; compound interest pays you on your principal and on every rupee of interest you have already earned.
The formulas
Simple interest grows linearly \u2014 the same interest amount every year:
Interest = P \u00D7 r \u00D7 t
A = P \u00D7 (1 + r \u00D7 t)Compound interest grows exponentially \u2014 each year's interest joins the base:
A = P (1 + r/n)^(n t)where P is the principal, r the annual rate as a decimal, t the time in years and n the compounding periods per year. See the full walkthrough in how to calculate compound interest.
Side by side: \u20B91,00,000 at 10% p.a.
| Year | Simple Interest | Compound (yearly) | Compound Advantage |
|---|---|---|---|
| 1 | \u20B91,10,000 | \u20B91,10,000 | \u20B90 |
| 5 | \u20B91,50,000 | \u20B91,61,051 | \u20B911,051 |
| 10 | \u20B92,00,000 | \u20B92,59,374 | \u20B959,374 |
| 20 | \u20B93,00,000 | \u20B96,72,750 | \u20B93,72,750 |
| 30 | \u20B94,00,000 | \u20B917,44,940 | \u20B913,44,940 |
After year one they are identical. By year 30, compounding has produced more than five times the interest of the simple contract \u2014 and the gap keeps accelerating, because simple interest adds a constant \u20B910,000 a year while the compound balance adds 10% of an ever-larger number.
When each type applies
- Simple interest: short-term personal and some auto loans, late-payment penalties, certain bond coupon calculations \u2014 usually contracts measured in months.
- Compound interest: savings accounts, fixed deposits, mutual funds, index funds, retirement accounts, reinvested dividends \u2014 essentially everything you hold for years. It also works against you on revolving credit-card debt.
The takeaway
For borrowers, simple interest is the cheaper structure. For investors, compounding is the whole game \u2014 and its power comes almost entirely from time, which is why starting early beats starting big.
See it for yourself: the Timeline Simulator has a Simple/Compound toggle in its global settings, so you can run the exact same plan both ways and watch the curves diverge. Or start with the SIP Calculator or Lump Sum Calculator.