Definition and Types of Interest Understanding interest in finances is important because it affects how much money you can earn or owe over time. In simple terms, interest is the extra money that is either paid to you when you save or invest money, or that you have to pay when you borrow money. It’s like a fee for using someone else’s money or a reward for letting someone else use your money.

Simple Interest There are two main types of interest: simple interest and compound interest. Simple interest is calculated only on the amount of money you originally put in or borrowed, known as the principal. For example, if you put $100 in a savings account with a 5% simple interest rate, you would earn $5 every year. The amount stays the same because it’s always 5% of the original $100.

Compound Interest Compound interest, on the other hand, is more powerful because it’s calculated not just on the principal, but also on any interest that has already been added. This means that with compound interest, you earn interest on top of interest. If you put that same $100 in a savings account with a 5% compound interest rate, you would earn $5 the first year, and then in the second year, you would earn interest on $105, not just $100. Over time, this can lead to much bigger earnings or debts.

Impact and Importance Understanding interest is important because it helps you make smarter financial decisions. If you know how interest works, you can choose better savings accounts to grow your money faster, or avoid getting into too much debt by being careful with how much you borrow and knowing how much extra you will have to pay back.