Interest is basically the principle that when someone lends you money, you have to pay the money back, plus a little bit extra for the service of them lending it to you. On the other side of the coin, if you lend someone money, you can expect them to pay you back plus a little extra.
So when you find a little more money in your savings account every now and then, it’s because the bank has essentially borrowed your money, invested it, and given you a little bit of a bonus for banking with them. And if your credit card bill seems to be higher than the amount that you’ve spent, that may be because you’ve copped interest on the outstanding balance you’ve yet to pay back.
Interest rates are involved in almost any financial service a bank provides. If you’ve got a savings account, you’re probably earning interest. If you’re taking out a loan, you’re going to have to pay it back with interest. If you’ve got a credit card, you’ll be paying interest on the outstanding balance you haven’t paid back. All of these services will have varying interest rates depending on which bank or financial institution you’re with, which is why it is so important to shop around to find the service that’s right for your needs.
Interest rates are also constantly changing, based on a whole bunch of economic factors like overseas interest rates, or more personal factors like how ‘risky’ the lender considers the borrower to be.
Basically, there’s simple interest and compound interest. Simple interest is, as the name suggests, pretty simple. Say you have $1000 in a savings account accruing 1% interest per annum for five years. At the end of the five years you’ll have $1050 – that’s $10 (or 1% of $1000) per year for five years.
The thing is though, most banks use compound interest, which means that each time the interest is paid (usually monthly), it’s paid on the accumulated total amount, rather than just the principal (or the initial) amount. So in the example above, the first month would pay $0.83 of interest, then the next month’s interest would be calculated on $1,000.83 (rather than just the original $1,000), and so on. After five years you’d have $1,051.25.
Basically, compound interest builds up slightly faster, both with profit and debt.