Interest shows up everywhere in personal finance: on savings accounts, loans, credit cards and mortgages. Understanding how it works can help you make better choices, whether you are saving or borrowing. The good news is that the core idea is simple.
In this guide we explain what interest is and the difference between simple and compound interest. The numbers we use are made up illustrations to show how the maths works. They are not real rates and not a prediction of what any product will pay or charge.
What interest is
Interest is the price of using money over time.
- When you borrow money, you usually pay interest to the lender. It is the cost of borrowing.
- When you save money in an account that pays interest, the bank pays you. It is a reward for keeping your money with them.
Interest is usually expressed as a percentage of the amount over a period, often a year. This percentage is called the interest rate.
Simple interest
Simple interest is calculated only on the original amount, which is called the principal. The interest does not change from one period to the next, because it is always based on the same starting amount.
An illustration
Imagine you put 1,000 in your local currency into an account that pays a made up simple interest rate of 5 percent per year.
- After year one, you earn 50 in interest.
- After year two, you earn another 50.
- After year three, another 50.
After three years you would have earned 150 in interest, for a total of 1,150. The interest is the same each year because it is always calculated on the original 1,000.
Compound interest
Compound interest is calculated on the original amount plus any interest that has already been added. In other words, you earn interest on your interest. Over time, this can make a noticeable difference.
The same illustration with compounding
Using the same made up figures, 1,000 at 5 percent per year, but compounded once a year:
| Year | Starting amount | Interest for the year | Ending amount |
|---|---|---|---|
| 1 | 1,000.00 | 50.00 | 1,050.00 |
| 2 | 1,050.00 | 52.50 | 1,102.50 |
| 3 | 1,102.50 | 55.13 | 1,157.63 |
After three years, compound interest gives a total of about 1,157.63 rather than 1,150. The difference is small at first, but it grows each year, because each year's interest is calculated on a larger amount.
Why time matters
The longer money compounds, the bigger the effect. In the early years, the difference between simple and compound interest is modest. Over many years, it can become much larger. This is why people often talk about the value of starting to save early. Even small amounts have more time to grow.
How often interest compounds
Interest can compound at different frequencies, such as yearly, monthly or daily. The more often it compounds, the slightly faster the balance grows, assuming the same rate. When you compare accounts, look for the rate that includes the effect of compounding. Many countries require providers to show a standard figure for this, though the name varies. Ask your provider if you are not sure which number to compare.
Compounding works on debt too
Compounding is helpful when you are saving, but it works the same way on many types of debt. If you borrow money and do not pay off the interest, that interest can be added to what you owe, and you then pay interest on it too.
This is one reason why carrying a balance on high interest debt, such as some credit cards, can become expensive over time. Paying more than the minimum, when you can, reduces the balance that interest is calculated on.
Questions to ask about any rate
Whether you are saving or borrowing, these questions can help you understand what you are signing up for:
- Is the rate fixed or can it change?
- How often does interest compound?
- Are there fees that affect the overall cost or return?
- Are there conditions, such as limits on withdrawals or minimum payments?
- What happens if I want to leave early or pay off early?
The answers should be in the product's terms. If anything is unclear, ask the provider to explain it, or speak to a qualified professional.
Putting it together
Simple interest is calculated on the original amount only. Compound interest is calculated on the original amount plus earlier interest, so it grows faster over time. Compounding can work in your favour when you save and against you when you borrow. Understanding the difference helps you read the terms of any account or loan with more confidence.