How does interest work?
What you'll learn
Understand interest and how compounding works for savers and against borrowers.
Interest is the price of money over time. As a saver, you earn it; as a borrower, you pay it. The thing that makes interest powerful is compounding: earning interest on your interest, year after year.
Simple vs compound
- Simple interest is paid only on your original amount.
- Compound interest is paid on your original amount plus the interest already added. That growing base is the snowball effect.
The longer money compounds, the bigger the gap. Time matters more than the exact rate.
The same force, two directions
| Situation | Who it favours | What happens |
|---|---|---|
| Savings account | You | Interest earns more interest |
| Long-term investing | You | Decades of compounding stack up |
| Credit card balance | The lender | Unpaid interest is charged interest |
| Payday or high-rate loan | The lender | Debt snowballs fastest of all |
Why it matters
The same maths that quietly builds a savings pot quietly deepens a debt. That is why clearing high-interest debt usually beats saving: the interest you stop paying is effectively a return you no longer have to earn.
Compare savings by AER and borrowing by APR, since both bake in compounding. Rates change often, so the chart above is illustrative only.
Key takeaways
- Interest is the cost of money over time; compounding is interest on interest.
- For savers, compounding is a slow, reliable tailwind.
- For borrowers, the same force works against you and grows debt.
- Time is the biggest lever, so starting early matters more than picking the perfect rate.
Illustrative only: £1,000 left untouched at a steady 5% a year, with interest itself earning interest. Real rates vary and savings rates change constantly. Not a forecast.
Frequently asked questions
What is the difference between simple and compound interest?
Simple interest is paid only on your original amount. Compound interest is paid on your original amount plus the interest already earned, so it snowballs over time.
Why is compound interest dangerous with debt?
On debt, compounding works against you. Interest is charged on the balance, and if unpaid that interest is added and itself charged interest, so debt can grow faster than you expect.
What does AER mean on a savings account?
AER (Annual Equivalent Rate) shows the yearly interest including the effect of compounding, so you can compare accounts fairly. APR is the borrowing equivalent for debt.
General information, not financial advice. The value of investments can fall as well as rise, and figures and rules can change; check the current position before acting.