Simple vs Compound Interest: What You Need to Know

Interest, often expressed as a percentage, is the cost of borrowing money from a lender. It can be one of two types: simple or compound. The difference between simple and compound interest lies in how they are calculated. While seemingly small differences in their formulas, the type of interest on a loan can drastically change what you pay over time.

Here’s what you need to know about simple vs compound interest.

Simple Interest vs Compound Interest

What is Simple Interest?

Simple interest is calculated based on the principal of the loan, or the amount you originally borrowed. So, in other words, the amount of interest you accrue each month will only be calculated based on the amount you initially borrowed.

What is Compound Interest?

Compound interest is calculated based on the principal of the loan plus any unpaid interest accrued on the loan. So, over time, interest will accrue on top of both the principal and any previously accrued interest.

Simple vs Compound Interest Example

Let’s say you had a principal loan balance of $30,000. For simplicity’s sake, let’s say it costs you $3 per day in interest to borrow that money.

With simple interest, it will cost you $90 per 30-day month in interest. ($3 x 30 days = $90)

With compound interest, your balance would increase to $30,003 on the first day. The next day, the interest amount would be calculated on a balance of $30,003, not the principal balance of $30,000. So, over time, the interest can accrue quite quickly as it compounds on itself.

Which is Better: Simple or Compound Interest?

If you have the option to choose between simple and compound interest, we recommend selecting simple interest.

Simple interest will often cost you less over time than compound interest because you will only pay interest on your principal loan balance. With compound interest, you will pay interest on your interest (say that 10x fast), which will inevitably cost you more over the life of your loan.

Here’s an example of how simple and compound interest would impact how much you pay over the life of the same loan.

	Simple Interest	Compound Interest*
Principal Balance	$30,000	$30,000
Interest Rate	5.8%	5.8%
Repayment Period	15 years	15 years
Total Paid Over the Life of the Loan	$56,100	$69,888
Total Interest Paid Over the Life of the Loan	$26,100	$39,888

While the two loans have the same principal balance, interest rate, and repayment period, the loan with compound interest would cost you $13,788 more over the life of the loan.

Are Student Loans Simple or Compound Interest?

All federal student loans operate on simple interest, and the vast majority of private student loans do, too. However, some private student loans do operate on compound interest, which often compound daily. To verify how your student loan interest is calculated, check with your lender directly.

Once you know how your student loan interest is being calculated, you can estimate your overall interest cost. To do so, use the simple and compound interest formulas.

Simple interest loans: Principal x interest rate x loan term = simple interest

Compound interest loans: (Principal (1 + interest rate)^ Number of compounding periods in a year) – principal = compound interest

As you can tell, the compound interest formula is a bit more complicated than the simple interest formula. If you have trouble doing the calculation by hand, you can utilize a compound interest calculator to help you.

How to Save on Student Loan Interest

Interest is often a major expense when it comes to borrowing a student loan. In fact, the average student loan accrues $26,000 in interest over the course of 20 years.

While opting for a simple interest loan is a great start to minimizing interest costs, there are a variety of ways to minimize it even further.

>> MORE: What is the average student loan interest rate?

Refinance Your Student Loan(s) 

Refinancing your student loan debt can result in significant savings in interest. In fact, borrowers who used Sparrow to refinance reduced their interest rate by 2.29 percentage points, saving them approximately $17,000 over the life of their new loan, on average.

>> MORE: Refinance student loans: Compare the best lenders

When you refinance, you essentially take out a new loan with a better interest rate or terms and then use the new loan to pay off your old loan.

Here’s how a 2.29% interest rate reduction could impact how much you pay over the life of your loan.

Principal Balance	Initial Interest Rate	Expected Total Payment Over the Life of the Loan	Interest Rate After Refinancing with Sparrow (Initial Interest Rate – Average 2.29% Savings in Interest)	Expected Total Payment Over the Life of the Loan with the New Interest Rate*	Savings from Refinancing
$10,000	8%	$17,202	5.71%	$14,909	$2,293
$30,000	6.5%	$47,040	4.21%	$40,514	$6,526
$50,000	5%	$71,171	2.71%	$60,905	$10,266

*Note that these numbers are based on a full 15-year repayment term, prior to making payments on the initial loan. The calculations will change based on how far into your repayment period you are, any surplus payments you may have made, and the new loan term you choose.

Add a Cosigner to the Loan

A cosigner is an individual who signs onto a loan alongside you, taking legal responsibility for paying back the loan should you fail to do so. A creditworthy cosigner gives lenders a “second line of defense,” if you will, lowering the risk for them to lend to you.

As a result, lenders will often offer you a lower interest rate on your student loan if you have a creditworthy individual cosign your loan.

>> MORE: What is a private student loan cosigner?

Negotiate Your Interest Rate

Believe it or not, you can actually negotiate your student loan interest rate. While it isn’t 100% effective, it can’t hurt to call up your loan servicer and ask for a lower interest rate.

See if the Lender Offers an Autopay Discount

Many private student lenders offer an interest rate discount, often 0.25%, for opting into autopay. By opting in to autopay, your student loan payments will automatically be withdrawn from your account each month. 

You should only opt in to autopay, however, if you are absolutely positive it will not result in an overdraft of your account.

>> MORE: How to save thousands on student loans with an autopay discount

Final Thoughts from the Nest

The type of interest you have on a loan can drastically impact how much you pay over the life of the loan. So, before borrowing, consider whether the loan has simple or compound interest.

To explore a variety of student loan options at low interest rates, submit the Sparrow application.