What is compound interest and why does it matter?

Compound interest is quite simply the way that debt grows.  If someone wants to borrow then they must understand what compound interest is and how it can make debt increase.

Interest is neither good nor bad.  It is only the price that a person pays to have the money now rather than getting the money later.  It is also the price that is paid to the lender for not spending the money as soon as they get it, but letting another person use it.  It also reflects the risk that the money may not come back and the administration that is involved.

Many people think of interest as an amount that is paid on the original balance.  So if there is a 5% interest on $200 then they will pay $10 in the first year, the second and every subsequent year.  This is quite easy to calculate as you simply multiply the percentage interest rate by the amount by the years in which the loan is outstanding.

This is not how compound interest works.  Compound interest is the interest that is charged on the interest.  So it is not just the original amount that has interest charged on it but also the interest that has accumulated and not been paid off.  The whole balance each year is taken into account.  This does not just mean that it is harder to calculate, but that the interest charged also rises faster at the same interest rate that is quoted.

This is used for almost every form of commercial lending, and this includes mortgages, personal loans and credit cards.

In our previous case if there had been compound interest than a 5% interest charge would mean that there would be a $10 charge in the first year.  In the second year the balance would be $210, and so the interest charge would be $10.50.  The 50 cent difference is the interest on the previous year’s $10 interest.

The longer the period in which the debt is left outstanding the faster the rate at which the total interest charge will grow.  This can often surprise people when they look at their loan after a couple of years and see how fast the debt has grown.  A 5% interest charge can take 14 years, rather than 20, to double and a 10% interest rate takes only seven years to double.

Compound interest means that it is important to understand what the interest rates are, and to pay off interest at a sensible rate.