It’s important to understand how compound interest differs from simple interest. With simple interest, you only earn interest on your original principal. So, using the same example of $1,000 at 5% over five years:
-
Simple interest = $1,000 + ($1,000 × 0.05 × 5) = $1,250
-
Compound interest = $1,276.28 (if compounded annually)
It may not seem like a big difference at first, but over 10, 20, or 30 years, compound interest can lead to thousands more in returns.