Compound interest and credit — Economics, 14–17 years
Interest is the price of using someone else’s money, or the reward for letting others use yours. Compound growth makes time important because interest can earn interest too.
Growth on top of growth
With simple interest, each period adds a percentage of the original amount. With compound interest, each period adds interest to the amount already built up, so later interest can be larger. For borrowing, the same process works in reverse: unpaid interest can make the debt grow.
Why does time matter?
Lenders give up the use of money now and face the risk that it will not return, so interest is a price for time and risk. Savers also want to know what their money may become later. Compound interest was used to solve the problem of comparing money available at different dates, though fees and risk still matter.
Saving for two years
You place €1,000 in an account paying 5% once a year. After year one: €1,000 × 1.05 = €1,050. After year two: €1,050 × 1.05 = €1,102.50. The extra €2.50 comes from earning 5% on the first year’s interest as well as on the original €1,000.
The trap: rate times years
A reasonable shortcut is to multiply 5% by 10 years and assume €1,000 becomes €1,500. That would describe simple interest, not annual compounding. With compounding, the amount is multiplied by 1.05 ten times, giving about €1,628.89 before tax or fees; the difference grows with time.
Where it helps
Compound interest appears in savings accounts, loans, credit cards and investments. It can reward regular saving, but it can also make a debt grow quickly when interest, fees or missed payments are added. Before borrowing, compare the total amount repaid, not only the attractive monthly payment.
Keep exploring
Other languages
Loading MyLeoNes™…