Interest on savings accounts and other types of accounts is calculated using either simple or compounding interest. Simple interest is calculated only on the amount of deposit, while compounding interest is calculated on principal, plus interest. More interest is earned on deposits when the compounding method is used.
The main difference between simple and compound interest is that simple interest is calculated only on the amount of the deposit. Simple interest is never calculated on previously earned interest. Because of this, compounded interest yields higher amounts.
Simple interest is calculated on deposits by using the following formula: Interest = Principal times rate times time (I = PRT). With simple interest, interest amounts are generally calculated only once. For example, if a person purchased a $500 certificate of deposit (CD) that contains a simple interest rate of six percent and is a two-year deposit, it is calculated using the simple interest formula. To calculate the amount of interest earned by the depositor, the equation is: I = ($500) x (6%) x (2). The interest earned for the two years is $60. When the person redeems this CD, he receives $560.
Compound interest is interest earned on deposits plus interest earned previously. When a deposit earns compound interest, the amount of the investment grows faster. Interest is calculated several times, depending on the investment. Compound interest may be compounded daily, weekly, monthly, quarterly or yearly. If the CD from the above example has compound interest calculated yearly, the interest is calculated differently than it was above. The same formula is used twice. The first time the interest is calculated is at the end of the first year, using the same formula: I = ($500) x (6%) x (1). The answer is $30. The investment is worth $530 at the end of year one.
At the end of year two, the principal amount changes. As a result, the equation changes: I = ($530) x (6%) x (1). This answer, $561.80, reflects the total value of the investment after year two.
Differences in the Example
The difference in the answers is caused by the difference in how the interest amount is calculated. The same investment is worth more money when interest is compounded. The difference in this example is minimal, but as the number of years of the investment increases, the difference can yield more varied results.