Interest Basics
Interest: A Cost and a Reward
Interest is one of the most important ideas in personal finance, and it works in two directions:
- When you save money in an account, the bank often pays you interest — a reward for letting them use your money in the meantime.
- When you borrow money, you pay interest to the lender — a cost for the privilege of using money that isn't yours yet.
The same basic idea, percentage-based extra money, applies whether you're the one earning it or the one paying it.
How Interest Is Calculated (Simple Interest)
The simplest form of interest, called simple interest, is calculated as a percentage of the original amount, applied over a set period of time.
Interest = Principal × Rate × Time
Where the principal is the original amount saved or borrowed, and the rate is the interest rate, usually expressed per year.
Worked Example — Saving
Imagine 500 units of currency is placed in a savings account paying 3% interest per year.
Interest earned in one year = 500 × 0.03 = 15 units of currency
After one year, the account holds 515 units of currency (assuming nothing else changes).
Worked Example — Borrowing
Now imagine borrowing 500 units of currency at a 6% annual interest rate, to be repaid after one year.
Interest owed = 500 × 0.06 = 30 units of currency
Total repayment = 500 + 30 = 530 units of currency
The exact same maths applies in both cases — only the direction of the money changes.
Why Interest Rates Differ
Not every account or loan offers the same rate. Interest rates are shaped by factors like:
| Factor | Effect on interest rate |
|---|---|
| How risky the loan seems to the lender | Higher perceived risk usually means a higher rate |
| How long the money is saved or borrowed for | Longer terms can affect the rate offered |
| General economic conditions | Rates can rise or fall across an entire economy over time |
| A borrower's repayment history | A strong history (see credit scores) can lead to lower rates |
Simple vs Compound Interest
The example above uses simple interest, calculated only on the original amount. Many real accounts and loans instead use compound interest, where interest is calculated on the growing total, including previously earned or charged interest. This can make a big difference over time — enough that it deserves its own lesson: compound interest.
Interest Shapes Big Decisions
Understanding interest is essential for almost every money decision covered elsewhere in this course — from why an emergency fund earning interest beats cash sitting idle, to why a credit card balance left unpaid can grow expensive quickly, to why starting to save early gives interest more time to work in your favour.
Key Words
- Interest — a cost of borrowing money, or a reward for saving it, usually a percentage
- Principal — the original amount saved or borrowed, before interest
- Interest rate — the percentage used to calculate interest, usually stated per year
- Simple interest — interest calculated only on the original principal