Now let’s compare what our investment value would be using the simple interest formula versus the compound interest formula.

Simple interest is only calculated on the principal amount—it doesn’t include interest accrued over time.

We’ll use the same example of $1,000 invested at 2% a year, with four payments per year for 10 years. Here’s the simple interest formula:

A = P (1+rt)

A = the total accrued amount (the principal + the interest)
P = the principal of $1,000
I = the interest rate of 2% which is $20, or $5 every quarter
r = rate of interest per year expressed in decimal form
t = the time period involved in months or years

A = $1,000(1 + 0.02*10)
A = $1,200 after 10 years

You would earn just $1,200 with simple interest over the same period of time, while with compound interest you accumulate 10% more, or $1,220.79.  

Compound interest is traditionally associated with money held in savings and checking accounts at banks, but because we’re in a period of extended low-interest rates, the benefits of compounding at a bank are pretty negligible. But dividend-paying stocks can provide similar advantages.