Interest

IMPORTANT FACTS- Interest

Interest is the reward for lending and the cost of borrowing. The interest rate is the percentage rate charged on a loan or paid on savings. For example, an annual interest rate of 5% means £5 is paid in interest for every £100 saved or borrowed.

IMPORTANT FACTS- Simple v. compound interest

• Simple interest is where you just pay interest on the original amount that is borrowed (the principal).

- In this example, the interest rate is calculated on a yearly basis.

- If I borrowed £100 at 10% annual interest rate then at the end of the year, I would have to pay £10 in interest.

- In total I would have to pay back £110 (£100 principal and £10 interest). If I borrowed £100 for 2 years at 10% then I would have to pay back £120 (£100 principal and £20 interest).

• Compound interest is where you pay interest on the original amount that is borrowed (the principal) and all on the accumulated interest.

- In other words, interest is added back to the original amount borrowed.

- If I borrowed £100 with compound interest at a 10% annual interest rate, after a year I would pay back £110 (£100 principal and £10 interest).

- If I want to keep borrowing the money for another year then I will have pay 10% on the original £100 and the £10 interest from the first year. This would mean that I would have to pay 10% on £110 which is £121.

• For shorter time frames, there might not be a significant difference between simple and compound interest but as lending time increases, the difference between the two types of interest grows. So if I borrowed £100 for 5 years with compound interest then I would have to repay £161, compared to £150 with simple interest. Most commercial loans use compound interest.

IMPORTANT FACTS- The effects of compound interest

The Millionaire curve demonstrates the effect of compound interest - if you save £2.65 a day from the age of 16 to 65 in a high interest account (9.45%) then you'll have over £1,000,000. However, bear in mind that compound interest can have a similar effect on debt!

VIDEO- A short video that highlights the benefits of compound interest on savings.

Interest calculations

TRIVIA

The sci-fi writer Douglas Adams parodies compound interest in his novel, The Restaurant at the End of the Universe. The restaurant's bill can be paid by depositing a penny in any bank account of the present time: by the end of the universe, the compound interest on that penny over the course of 170 quintillion years will be enough to pay the extremely high bill.