A savings account quotes "APY", a fund shows "1-year return", a bank advertises "IRR". Same word "return", very different meanings — mix up the methods and your numbers are meaningless. Here's how simple interest, compound interest, and IRR really differ.
Simple Interest: Interest Doesn't Compound
Simple interest: only the principal earns interest; interest never earns interest. Used for term deposits and bond coupons.
Formula: Final value = Principal × (1 + annual rate × years)
Example: $10,000 at 5% for 5 years → 10,000 × (1 + 0.05×5) = $12,500
Compound Interest: Interest on Interest
Compound interest: each year's interest joins the principal, so next year's interest grows too. Used for long-term investing, funds, and compounding accounts.
Formula: Final value = Principal × (1 + annual rate)^years
Same $10,000 at 5% for 5 years → 10,000 × 1.05^5 ≈ $12,763
Only $263 apart over 5 years — but over 30 years simple gives $25,000 while compound gives ≈ $43,200. Compound interest is time's best friend. Project any horizon with the compound interest calculator.
IRR: The "Honest" Rate for Real Cash Flows
IRR (internal rate of return) is the most truthful of the three: it accounts for when each dollar flows in and out. It's the right tool for dollar-cost averaging, loans, and installment plans.
Why not use simple annualized returns for DCA? Your monthly $100 — the first dollar has compounded for a year, the last just entered. A simple average overstates the result. Only IRR discounts every cash flow back to a common time value.
Worked Example: The Real Return of Monthly Investing
Invest $100/month for 12 months; account ends at $1,300. A naive calc says "$100 profit on $1,200 ≈ 8.3%". But IRR on those cash flows comes to roughly 15% — because most of the money was only invested for a few months.
If you instead lump-summed $1,200 and earned $100, IRR would be 8.3%. Same profit, different cash flows, wildly different rates.
Which Method to Use
| Method | Best for | Character |
|---|---|---|
| Simple interest | Term deposits, bonds | Conservative, intuitive |
| Compound interest | Long-term investing | Shows true compounding |
| IRR | DCA, loans, installments | Most accurate, cash-flow aware |
Bottom Line
Before comparing any investment, ask which rate is quoted: simple, compound, or IRR. Numbers from different methods are not comparable. Use the CAGR calculator for annualized compound returns and the compound interest calculator for future values — and compare everything on the same ruler.