Interest: when money grows, and when it costs you

Interest is the price of using someone else's money. When you put money in a savings account, the bank uses it and pays you interest. When you borrow money, you pay interest to the lender. The interest rate tells you how much, as a percentage of the amount, usually for one year.

Simple interest

Simple interest is worked out on the starting amount only. The rule is I = P × r × t:

So I = 500 × 0.04 × 3 = $60, and after three years you have $560.

Compound interest

Most real savings accounts pay compound interest: each year's interest is added to your balance, and next year you earn interest on the interest too. $500 at 4% becomes $520 after one year, then $540.80, then about $562.43 after three years. That is only $2.43 more than simple interest after three years, but after 40 years the difference is huge. This is why people say time is a saver's best friend.

Borrowing uses exactly the same maths, but now the interest works against you. A loan or credit card at 20% interest grows fast if it isn't paid off. That is why it is worth checking the interest rate, the fees and the total you will repay before you borrow anything.

Start early

Imagine travelling 600 km. With ten hours you can drive at a relaxed 60 km/h; with three hours you would need to go 200 km/h. Saving is the same: start early and small, steady amounts get you there. Start late and you have to save much more, much faster.