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Understand how compound interest can help your savings grow over time. There are different interest schedules. Compounding and simple are the most common. Compound interest is a type of interest calculation. When someone lends you money (e.g. a loan) they don’t do this for free. They require you to pay a little extra for the use of their money. This “extra” is called interest. Compound interest is interest which is calculated at a specific time interval (e.g. monthly) and includes any and all outstanding loan balance (including the accumulated interest amount). Simple interest is calculated only on the remaining principal (original loan amount).
Here is an example how compounding interest and simple interest play out in a $1,000 loan which needs to be paid back in 5 years:
| Year | Simple Interest Paid | Compounding Interest Paid |
|---|---|---|
| 1 | $50.00 | $50.00 |
| 2 | $100.00 | $102.50 |
| 3 | $150.00 | $157.63 |
| 4 | $200.00 | $215.51 |
| 5 | $250.00 | $276.28 |
Because interest is calculated differently (simple is based on remaining principal balance and compound on principal plus accumulated interest), the total amount repaid is different.
