Simple interest vs compound interest

Simple interest vs compound interest

Want to work towards financial freedom? One of the most effective ways to start is to open a savings account and build up a financial safety net. These days, South African financial institutions offer a range of savings products, making it easier to compare accounts and choose one that suits your needs.

When you put money away every month, the interest you earn is what grows your savings over the long term. Interest is usually split into two main categories: simple interest and compound interest. Let’s look at how they differ and why the distinction matters.

What is simple interest?

Simple interest is calculated only on the original amount you saved, which means your interest earnings grow in a straight line rather than accelerating over time. It’s straightforward, but not as powerful as compound interest for long-term savings.

Example:

If you put R100 into a savings account for three years and the bank pays 10% interest annually, at the end of the first year the interest you’ve accumulated will be:

R100 × 10% = R10

This gives you a total of R110. Even though you now have more money than you started with, the interest continues to be calculated only on the original R100. Here’s how it works over three years:

Year	Calculation	Total
Year one	R100 × 10% = R10	R100 + R10 = R110
Year two	R100 × 10% = R10	R110 + R10 = R120
Year three	R100 × 10% = R10	R120 + R10 = R130

After three years, you’ll have R130 in your savings account.

What is compound interest?

Compound interest is calculated on the original amount you saved and on the interest that has already built up. In other words, you earn interest on interest. This is why compound interest is often described as powerful for long-term savings and investments.

Example:

If you put R100 into a savings account for three years and the bank pays 10% interest annually, at the end of the first year the interest you’ve accumulated will be:

R100 × 10% = R10

You now have R110 in total. In the next year, you earn 10% on the full R110, not only on the original R100. Here’s how it works over three years:

Year	Calculation	Total
Year one	R100 × 10% = R10	R100 + R10 = R110
Year two	R110 × 10% = R11	R110 + R11 = R121
Year three	R121 × 10% = R12.10	R121 + R12.10 = R133.10

After three years, you’ll have R133.10 in your savings account, which is more than with simple interest.

Comparing simple interest and compound interest

In the example above, R100 is saved in two different accounts. The blue line represents simple interest, while the red line represents compound interest. Over 40 years, the compound interest has grown by R4 425.93, while the simple interest has grown by R400.

This shows how compound interest grows your money much faster than simple interest over long periods. Simple interest is commonly used for certain loans, such as car finance, because it keeps repayments more predictable. Compound interest, on the other hand, is ideal when you’re saving and want your money to grow as much as possible.

In an ideal world, you’d prefer to pay simple interest on borrowings and earn compound interest on savings. The key is to start saving as early as you can. Your money may grow slowly at first, but over the years compound interest can accelerate that growth. Even a small amount saved every month can make a meaningful difference.

If you’re working towards financial freedom, consider building up your savings by comparing savings accounts on Hippo.co.za today.

Prices quoted are correct at the time of publishing this article. The information in this article is provided for informational purposes only and should not be construed as financial, legal or medical advice.

Sources: Investopedia; Siyavula.