Basic difference between simple and compound interest

Let's walk through an example. Imagine you’ve used $5,000 of credit on a line with 18.0% APR (the typical APR for most credit cardholders carrying a balance). The simple interest calculation, the most basic calculation, says that at the end of the year, you would owe $5,900 — the original $5,000 plus $900 (=$5000 x 18.0%) in interest. Of course, you won’t wait a whole year to pay this off, so in practice, the annual rate (APR) gets translated to a daily interest rate of 0.0493% (18% / 365 days). With simple interest, every day you haven’t paid off the debt, you will be charged the daily rate of interest on the original $5,000.

The chart below compares simple interest to compound interest.

Simple 18% APR Compound 18% APR
Days Principal Interest Principal Interest
1 $5,000 $2.465 $5,000 $2.465
2 $5,000 $2.465 $5,002.47 $2.467
3 $5,000 $2.465 $5,004.93 $2.468
4 $5,000 $2.465 $5,007.40 $2.469
5 $5,000 $2.465 $5,009.87 $2.471
6 $5,000 $2.465 $5,012.34 $2.472
7 $5,000 $2.465 $5,014.81 $2.473
8 $5,000 $2.465 $5,017.29 $2.475

First, notice that your principal grows under compound interest. That’s right, even though you initially used only $5,000 in credit, every cent of interest you get charged gets added to your principal to be charged interest again. Even so, you’re still probably thinking these two interest totals are essentially the same. And that’s true: on an 8-day horizon, the difference between simple and compound interest is a few cents. And if you could pay off your $5,000 debt just 8 days after you’ve spent it, then you wouldn’t care what kind of interest it was, just what the rate is.

But what does it look like as we go on?

Days Simple Compound Difference
8 $19.72 $19.76 $0.04
30 $73.97 $74.50 $0.53
60 $147.95 $150.12 $2.17
180 $443.84 $464.01 $20.18
365 (1 yr) $900.00 $985.82 $85.82

Compound interest is great news for your savings accounts (if they weren’t stuck at sad sub-0.5% interest rates) but not when it comes to your interest charges. Sure, at the three-month mark we’re looking at less than $10, but by the first anniversary we’ve got an $85 difference, and that’s beginning to sound like real money.

Credit card companies know this and like this. Why else is the minimum payment so low? Why else do they try to tack on as many fees as possible? To sneak it into that compounding formula. Because while compounded interest starts out small, it grows faster than you can imagine, and before you know it, it’s the interest alone that’s keeping you in debt.

We believe this is wrong. Simple interest is fair and makes sense. It’s something everyone can calculate. Compounding is a fancy word for stealing, and we won’t have any of it.