Simple interest vs compound interest: Understanding the difference

Simple interest is a type of interest that is occasionally used by savings accounts to earn interest and help your money grow. It works by giving you a fixed interest payment over a set period, depending on what you choose.  

For example, if you invest $10,000 at 3 per cent for five years, you would receive $300 in interest per year and $1,500 in interest at the end of 5 years. It means your savings will grow to $11,500 at the end of 5 years.

This interest type is most commonly used with some term deposits or some types of loans as long as you continue payments.

Another type of interest used with savings accounts is compound interest. When you earn compound interest, you earn interest on top of any interest you've already earned on your savings. This means you earn interest; it’s paid and added to your savings, and it’s included in the subsequent calculation to earn interest; hence it’s compounded. This is how most Australian savings accounts and term deposits earn interest. 

Instead of waiting for interest to be paid at the end of a period, you have it calculated and paid incrementally. Depending on your account, these increments can be quarterly, monthly, weekly, or even daily. As the interest payments compound, your savings will rise even quicker.

 For example, imagine you have $10,000 invested at 3 per cent per year and choose to have the interest paid monthly. You’ll have earned $1,661 in interest over five years - an extra $161 compared to an account with simple interest. And this is without having a regular savings plan that would increase your investment amount.

 This is where compound interest can significantly affect how you grow your wealth.