Do you know the difference between simple interest and compound interest?
In this article we explain everything you need to know about interest earned on term deposits/investments.
Interest is a fundamental component of personal finance and investments. Understanding the difference between simple and compound interest allows you to make more informed and profitable decisions, both in investments and loans. We’ll explain both types of interest and show you how they influence the growth of your money.
1. What is simple interest?
Simple interest is calculated only on the initial amount invested, i.e. the capital. There is no capitalisation of interest, which means that interest is always calculated on the same initial amount each period.
Simple interest formula:
Simple Interest = Initial Capital x Interest Rate x Time
Example of calculating simple interest:
Suppose you invest €3,000 at an annual interest rate of 5% for 3 years.
Simple Interest = €3,000 x 0.05 x 3 = €450
Therefore, at the end of 3 years, the total amount of interest earned would be €450, and the final amount would be:
Total Amount = Initial Capital + Simple Interest
Total Amount = €3,000 + €450 = €3,450
2. What is compound interest?
In compound interest, the interest generated is added to the initial capital, and in the following period, interest is calculated on this new amount (capital + interest). This creates an ‘interest on interest’ effect, which can increase the yield over time.
Compound interest formula:
Total Amount = Initial Capital x (1 + Interest Rate) ^ Number of Periods
Example of compound interest calculation:
Suppose you invest €3,000 at an annual interest rate of 5%, with annual capitalisation, for 3 years.
At the end of each year, the interest calculation will be:
1st year:
Interest = €3,000 x 0.05 = €150
Capital after 1st year = €3,000 + €150 = €3,150
2nd year:
Interest = €3,150 x 0.05 = €157.50
Capital after 2nd year = €3,150 + €157.50 = €3,307.50
3rd year:
Interest = €3,307.50 x 0.05 = €165.38
Capital after 3rd year = €3,307.50 + €165.38 = €3,472.88
Therefore, the total amount at the end of the 3 years would be €3,472.88, with a total accumulated interest of €472.88. In this case, compound interest generated more income than simple interest.
3. Comparing simple and compound interest
| Characteristics | Simple Interest | Compound interest |
| Interest Calculation | On the initial capital | On capital + interest |
| Interest Example (3 years) | €450 | €472,88 |
| Final Amount (3 years) | €3.450 | €3.472,88 |
| Best for | Short term | Medium/long term |
4. When to use compound interest?
Compound interest is especially advantageous for long-term investments. The longer the investment period, the greater the capitalisation effect, which allows earnings to grow exponentially. This type of interest is often used in products such as:
- Term savings;
- Investment funds;
- Retirement Savings Plans (PPR).
5. The importance of inflation
If you invest or save without taking inflation into account, you could end up losing purchasing power. Inflation causes the real value of money to decrease over time. It is therefore important that the interest rate you earn is higher than the inflation rate so that your capital stays the same or increases in real terms.
Conclusion: Knowing the difference between simple and compound interest allows you to manage your money better. If your goal is to maximise long-term earnings, compound interest is undoubtedly the best choice.
Understanding these concepts helps you make more informed and strategic financial decisions. If you still have doubts or want to know more, take a look at our investment solutions and see how you can apply these strategies in practice!
The information in this article does not constitute any personalised recommendation and does not dispense with consulting official and legal entities for an informed decision.
