Understanding the difference between simple interest and compound interest is a very important concept if you are trying to create wealth. Compound interest is like a rocket ship and simple interest is akin to roller blades when you compare the two over time.

Let’s look at the following example.

**Simple Interest**

You walk into your local bank branch of Dewie Cheatem & Howe with $5,000 to invest. After sitting down with one of their representatives, he offers you a great deal on one of their products. This product will pay you 10% simple interest per year. This seems like a good deal and you jump at it. After year one, your $5,000 has grown to $5,500. Not too bad. Year two you earn the same $500. However, year two, you actually had $5,500, so the percentage you earned is really less than 10%. Simple interest does not earn interest on interest, but earns interest only on the original principal. Look at the following.

**Year One**

$5000 X 10% = $500 Interest. You now have $5,500

**Year Two**

Since you are earning simple interest, you are only earning interest on your original principal which is $5,000, even though you have $5,500. So the interest is still $500.

The first year you earned a true rate of 10%. However, the second year, your effective interest rate is about 9%. At the end of 5 years you would have $7,500.

**Compound Interest**

You have $5,000 to invest and you find a product that pays you 10% interest which is compounded yearly. After year one, your return does not look much different than the person who is receiving simple interest as you both have $5,500. However, time is what makes compound interest so powerful, as you will see in the next years.

**Year One**

$5000 X 10% = $500 interest. As with the simple interest, you have $5,500 at the end of the year.

**Year Two**

$5,500 X 10% =$550 interest. Now you are getting 10% on the interest you earned. At the end of 5 years, your $5,000 will have grown to $8,052.55. Compounding this way you will have received $552.55 more over 5 years.

The more time you have and the frequency in which money is compounded is one of the keys to creating wealth.