Simple vs. compound interest: which one is on your loan or savings?

Most people learn the difference between simple and compound interest once in school and then forget it. That's a shame, because knowing which one applies to your car loan, your credit card or your savings account can change how you handle each of them.

Simple vs. compound interest in one sentence each

Simple interest is charged or paid only on the original amount. Compound interest is charged or paid on the original amount plus any interest already added.

Simple: I = P × r × t
Compound: A = P(1 + r/k)^(k × t)

Side-by-side: $10,000 at 6%

For the first few years, the two are almost identical, which is why the difference feels abstract. Over decades, compounding produces more than twice the growth. Check the numbers yourself with the simple interest calculator and the compound interest calculator.

Year by year: how the gap opens

At 6%, simple interest adds a flat $600 a year. Compounding multiplies by 1.06 each year, so the gap starts at zero and widens every year.

Do car loans use simple or compound interest?

Most auto loans use simple interest, calculated daily on the principal you still owe. Each payment covers the interest built up since the last one, and the rest reduces the balance. Two practical consequences: paying a few days early or adding a little extra lowers future interest, while paying late does the opposite. The auto loan calculator shows how rate and term change the total.

Do credit cards charge compound interest?

Effectively, yes. Most cards calculate interest daily, and any interest you don't pay off becomes part of the balance that's charged interest the next day. At typical card rates, that's why a balance you're only paying the minimum on can feel like it barely moves.

A quick simple interest example

Say a friend lends you $5,000 at 8% simple interest for three years, repaid in one lump sum at the end. The interest is $5,000 × 0.08 × 3 = $1,200, so you'd repay $6,200. Had the same loan compounded yearly, you'd owe about $6,299. The gap looks small here because the loan is short; stretch it to fifteen years and it becomes several thousand dollars.

Is mortgage interest simple or compound?

Most mortgages sit somewhere in between, which is why people argue about it. Interest is calculated each month on the balance you still owe, much like simple interest on the outstanding principal. But because every scheduled payment covers that month's interest in full, unpaid interest never builds up and gets added to the balance. So in practice, as long as you pay on time, you're not paying interest on interest. Our guide to how mortgage payments are calculated shows how each payment is split.

What is interest capitalization?

Capitalization is the moment when unpaid interest is added to your principal. From then on, you pay interest on it, and a simple-interest loan starts behaving like a compound one. It often happens with student loans after a period of deferment or forbearance, and with some loans when payments are skipped or reduced.

A quick example: if $2,000 of unpaid interest is capitalized onto a loan at 6%, you'll pay about $120 a year in extra interest on that interest alone, for as long as it stays on the balance. If you have the choice, paying interest as it accrues, even during a deferment period, prevents this.

What does paying late cost on a simple-interest loan?

On a daily simple-interest loan, timing matters. On a $25,000 car loan balance at 7%, interest builds at about $4.79 a day. Pay ten days late and that's roughly $48 of extra interest, on top of any late fee, and less of your payment goes to principal. Pay a few days early and the opposite happens. It's a small amount each month, but it adds up over a five-year loan.

Before any late fee the lender charges.

How to find out which type your loan uses

Look in your loan agreement or disclosure for phrases like "simple interest", "daily simple interest", "compounded monthly" or "capitalization". If it isn't clear, ask the lender directly how interest is calculated and when unpaid interest would be added to the balance. It's a reasonable question, and the answer affects how you should pay.

A quick way to think about it

If you're saving, you want compounding, a good rate and as much time as possible. If you're borrowing, you want simple interest, a low rate and as little time as possible. Most money decisions come down to getting on the right side of that equation.