Simple vs. Compound Interest: The Snowball Effect

Interest is the price of money — what you earn when you lend or save, and what you pay when you borrow. But how that interest is calculated makes an enormous difference over time. There are two flavors: simple and compound.

Simple interest is paid only on the original amount, called the principal. Say you deposit $1,000 at 10% simple interest per year. Every year you earn a flat $100 — because it's always 10% of the same $1,000. After 3 years you'd have $1,300, and the yearly payout never changes.

Compound interest is paid on the principal plus all the interest already accumulated. That same $1,000 at 10% compounded yearly earns $100 the first year (now $1,100), then $110 the second year — 10% of $1,100 — reaching $1,210, then $121 the third year for $1,331. Your interest earns interest, so the balance grows faster and faster, like a snowball rolling downhill.

The gap looks tiny at first ($1,331 vs. $1,300), but over decades it becomes dramatic. This is the engine behind the compound interest you met earlier: it works powerfully for you when saving and investing, and painfully against you when it's added to debt like a credit card balance.