Short answer
Simple interest uses the original principal as its calculation base; compound interest includes accumulated interest in that base. With $1,000 at 5% annually, both produce $50 in the first year, but annual compounding produces $52.50 in the second year instead of another $50. 1 2
On this page
At a glance
Scroll to compare all columns →
| Attribute | Simple interest | Compound interest |
|---|---|---|
| What earns interest? | Original principal | Principal plus accumulated interest |
| Second-year interest: $1,000, 5%, annual calculation | $50 | $52.50 |
| Five-year total in the SEC example | $1,250 | $1,276.28 |
| Key calculation detail | Principal stays the interest base | Compounding interval determines when interest joins the base |
These figures use the sources’ unchanged-principal examples. 1 2
What each thing is
Principal is the starting amount, not the interest it generates. Simple interest keeps that original amount as the basis for earnings. Compound interest adds an additional layer: previously earned interest participates in subsequent calculations. The CFPB calls the timing of those calculations the compounding frequency. 1 2
Key differences
For the stated annual examples, simple interest adds the same dollar amount each year: 5% of $1,000 is always $50. Annual compounding instead applies 5% to each year’s starting balance. After the first year, that balance is $1,050, so the next calculation includes $2.50 earned on earlier interest. 2
How to tell them apart
Identify the balance used for the next interest calculation: original principal alone indicates simple interest; principal plus earlier interest indicates compounding. Payment frequency alone is not enough. The SEC describes brokered CDs that pay interest monthly, quarterly, or semiannually but generally pay simple interest rather than compound it inside the CD. 2
Where they overlap
Both methods can start with the same principal and stated annual rate, and their first-year results can match. In the SEC’s annual example, both reach $1,050 after one year. That matching result does not establish identical mechanics; the difference appears when previously earned interest enters later calculations. 2
Edge cases
A simple-interest CD can be part of a broader arrangement in which interest earns more interest. The SEC explains that cash interest from a brokered CD must be reinvested in another account to earn additional interest. That outside reinvestment does not mean the original CD compounds internally. 2
Why the distinction exists
The distinction separates earnings on the original money from earnings on earlier earnings. Repeating the latter calculation creates a growing gap: in the SEC’s five-year example, compounding adds $26.28 beyond the simple-interest result. The CFPB also identifies compounding frequency as a factor affecting savings growth. 1 2
Common misconceptions
A 5% rate alone does not specify the full calculation: the interest base and compounding frequency also matter. Nor does a growing total prove compounding—simple-interest earnings can increase total value without increasing the balance that earns interest. The SEC’s simple-interest example reaches $1,250 while still calculating annual interest on $1,000. 1 2
Examples
Case 1: In the CFPB’s savings example, $1,000 at 5%, compounded annually, becomes $1,102.50 after two years because year-two interest uses $1,050. Case 2: In the SEC’s simple-interest comparison, $1,000 at 5% annually produces $50 each year and a five-year total of $1,250; earlier earnings never enter the interest base. 1 2