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Interest is the cost of borrowing money — or the reward for lending it. When you deposit money in a savings account, the bank pays you interest for letting them use your funds. When you take out a loan, you pay interest to the lender in return.
Interest can be calculated in two ways: simple interest and compound interest. Understanding the difference between them is key to making smarter financial decisions.
Simple interest is the most straightforward way to calculate interest. It's based only on the original amount — called the principal — and never changes over time. Here's a quick example:
Miguelito borrows $100 from the bank at a 10% annual interest rate for one year. The interest he owes is:
So after one year, Miguelito pays back the original $100 plus $10 in interest:
Now, what if he borrows that same $100 for two years instead? With simple interest, the calculation stays the same each year — always based on the original $100:
After two years, Miguelito owes $120 total — $100 in principal and $20 in interest. The general formula for simple interest is:
When interest is applied more frequently — say monthly or daily — the formula adjusts slightly:
In practice, simple interest is rarely used. Most real-world financial products — savings accounts, loans, credit cards — use compound interest instead.
Compound interest works differently from simple interest because you earn (or owe) interest on your accumulated interest, not just the original amount. This creates a snowball effect over time.
Let's revisit Miguelito's example. He borrows $100 at 10% interest for two years, but this time with compound interest. The first year looks the same:
After year one, Miguelito owes $110. But here's where compounding kicks in — in year two, the interest is calculated on $110, not the original $100:
That extra dollar comes from earning interest on the $10 of interest from year one. Adding it up:
With compound interest, Miguelito owes $121 — compared to just $120 with simple interest. The difference may seem small here, but over longer periods and with larger amounts, compounding can dramatically increase returns (or costs).
The more frequently interest compounds — monthly, daily, or even continuously — the faster your money grows. This is the power of compound interest that makes it such a cornerstone of investing and personal finance.
Want a quick way to estimate how long it takes to double your money? The Rule of 72 is a handy shortcut. Simply divide 72 by your interest rate, and you'll get an approximate number of years.
For example, how long would it take to double $1,000 at an 8% interest rate?
At 8% interest, your $1,000 would grow to roughly $2,000 in about 9 years. This rule works best for interest rates between 6% and 10%, but gives reasonable estimates for anything under 20%.
Interest rates come in two flavors: fixed and floating. A fixed rate stays the same for the entire term of the loan or investment, making it predictable and easy to plan around. A floating (or variable) rate, on the other hand, moves up and down based on a benchmark — like the U.S. Federal Reserve's funds rate or SOFR (Secured Overnight Financing Rate).
Typically, loan rates sit a bit above the benchmark, and savings rates sit a bit below — the difference is how banks earn their profit. Fixed rates offer stability, while floating rates can be lower initially but carry the risk of rising over time.
Regular contributions — whether weekly, monthly, or yearly — can supercharge the effect of compound interest. Even small, consistent deposits add up significantly over time because each contribution starts earning its own interest right away.
One detail worth noting: whether you contribute at the beginning or end of each period makes a difference. Contributions made at the beginning get one extra compounding period, which means slightly more growth over time.
Taxes can take a meaningful bite out of your investment returns. Many forms of interest income — from bonds, savings accounts, and certificates of deposit (CDs) — are subject to taxation.
For example, if Miguelito invests $100 at 6% for 20 years with no taxes, he'd end up with:
But if Miguelito faces a 25% tax rate on his interest each year, his final balance drops to just $239.78. That's because the tax is applied to each compounding period, reducing the amount that earns interest the following year.
Inflation is the gradual increase in prices over time, which means a dollar today won't buy as much in the future. In the U.S., inflation has averaged around 3% per year over the past century. For context, the S&P 500 has returned roughly 10% per year over the same period.
If you want a quick estimate without worrying about inflation, leave the inflation rate at 0 in the calculator above. For a more realistic picture of your future purchasing power, enter an expected inflation rate.
When you factor in both taxes and inflation, growing the real value of your money becomes a real challenge. For example, with a 25% tax rate and 3% inflation, you'd need to earn at least 4% just to break even — and that's before any real growth begins.