If you borrow someone's bike for a week, you give the bike back. Nobody expects you to return a bike and a half. Money is different: borrow £100 and you pay back more than £100. The extra bit is interest, and there is a good reason it exists.
Why anyone charges it
When somebody lends you money, three things happen to them. They cannot use that money themselves while you have it. Prices generally rise, so the money is worth slightly less by the time it comes back. And there is always a chance you never return it at all.
Interest is the price that covers all three. It is what you pay for the use of somebody else's money, in the same way rent is what you pay for the use of somebody else's flat.
The one thing to remember
Interest works in both directions. When you borrow, you pay it — borrowing costs more than the thing cost. When you save, you receive it — the bank is borrowing your money and paying you rent for it. Same mechanism, opposite seat.
How the rate works
Interest is written as a percentage per year. 5% a year means for every £100, £5 is added over twelve months.
| Amount | Interest at 5% | After one year |
|---|---|---|
| £20 | £1.00 | £21.00 |
| £100 | £5.00 | £105.00 |
| £500 | £25.00 | £525.00 |
| £2,000 | £100.00 | £2,100.00 |
To work it out yourself: divide the percentage by 100, then multiply by the amount. 5% of £60 is 0.05 × 60 = £3.
Simple interest and compound interest
Simple interest
Simple interest is always calculated on the amount you started with. £100 at 5% simple interest earns £5 every year, for ever: £105, £110, £115, £120.
Compound interest
Compound interest is calculated on what you have now — including the interest already added. So the interest itself starts earning interest.
| Year | Simple interest | Compound interest | Difference |
|---|---|---|---|
| 1 | £105.00 | £105.00 | — |
| 2 | £110.00 | £110.25 | £0.25 |
| 5 | £125.00 | £127.63 | £2.63 |
| 10 | £150.00 | £162.89 | £12.89 |
| 25 | £225.00 | £338.64 | £113.64 |
| 40 | £300.00 | £703.99 | £403.99 |
Look at year 40. Simple interest has tripled the money. Compound interest has multiplied it by seven. Nothing changed except that the interest was allowed to earn interest — and time did the rest.
The rule of 72
Want to know how long compound interest takes to double your money? Divide 72 by the interest rate.
- At 6%: 72 ÷ 6 = 12 years to double.
- At 3%: 72 ÷ 3 = 24 years to double.
- At 24% — a fairly ordinary credit card rate — 72 ÷ 24 = 3 years for a debt to double if you never pay anything off.
It is an approximation, but it is close enough to be genuinely useful, and you can do it in your head.
The same power, pointed the wrong way
Everything that makes compound interest wonderful for savers makes it dangerous for borrowers. A debt left unpaid grows on its own, and it grows faster the longer it is left — the interest gets added to the debt, and then that gets charged interest too.
This is why credit card debt has a reputation for getting out of hand. It is not that the rate is enormous by the standards of borrowing. It is that the rate is applied to a total that keeps growing, and the minimum payment is designed to barely dent it.
The words you will see written down
| Term | What it means |
|---|---|
| APR | Annual Percentage Rate. The cost of borrowing over a year, including compulsory fees as well as interest. It exists so you can compare two loans fairly. |
| AER | Annual Equivalent Rate. The savings version — what you will actually earn over a year with compounding included. |
| Base rate | The rate set by the Bank of England. Most other rates in the country move up and down roughly with it. |
| Fixed / variable | A fixed rate stays the same. A variable rate can change, which means your payments can change too. |
Once you can read those four, you can read most of a financial advert — which is a more useful skill than it sounds, because the important numbers are usually the small ones.
Questions people ask
- What is interest in simple terms?
- Interest is the price paid for using someone else's money — a bit like rent. If you borrow, you pay it. If you save, the bank pays it to you for using your money.
- What is the difference between simple and compound interest?
- Simple interest is always worked out on the amount you started with. Compound interest is worked out on what you have now, including interest already added, so the interest starts earning interest. Over long periods the difference is enormous.
- What is the rule of 72?
- Divide 72 by the interest rate to estimate how many years it takes for money to double. At 6% it is about 12 years. It works for debts too — a 24% debt roughly doubles in three years if nothing is repaid.
- What does APR mean?
- APR stands for Annual Percentage Rate. It is the yearly cost of borrowing including compulsory fees as well as interest, designed so that two different loans can be compared fairly.