Simple Interest
Simple interest is calculated only on the original amount - the principal. Borrow $1,000 at 10% simple interest per year, and you owe $100 a year, every year, no matter how long the loan runs. After three years you have paid $300 in interest. The rate never touches the interest that already accrued.
Some auto loans and personal loans use simple interest. It is predictable and, for the borrower, the gentler of the two.
Compound Interest
Compound interest is calculated on the principal plus the interest already added. Interest earns interest. That small difference becomes enormous over time.
Take that same $1,000 at 10%, compounded annually. Year one adds $100 (balance $1,100). Year two charges 10% on $1,100 - $110 (balance $1,210). Year three, $121. The interest grows each period because the base it is calculated on keeps growing. Over long horizons the curve bends sharply upward.
A rough shortcut is the Rule of 72: divide 72 by the interest rate to estimate how many years it takes for an amount to double. At 8%, money doubles in about 9 years. At 24% - a typical credit card rate - a balance left unpaid roughly doubles in just 3.
Compounding Cuts Both Ways
This is the single most important idea in personal finance: the exact mechanism that builds wealth in a long-term investment is the mechanism that traps people in debt.
- In your favour: Money invested early compounds for decades. This is why starting to invest young beats investing more later - a lesson explored in how dividends reinvest.
- Against you: Credit card balances compound - often monthly. Carry a balance and you pay interest on last month's interest. This is why high-interest debt is the first thing to eliminate.
APR vs APY: Read the Right Number
Two acronyms describe an interest rate, and lenders choose whichever flatters them.
- APR (Annual Percentage Rate): The yearly rate before compounding within the year. Loans and credit cards are usually quoted in APR.
- APY (Annual Percentage Yield): The effective yearly rate after compounding is included. Savings accounts advertise APY because compounding makes it look higher.
The takeaway: when you borrow, the true annual cost is usually a little higher than the stated APR because of within-year compounding; when you save, the APY is what you actually earn. Compare like with like.
Why This Changes How You Pay Down Debt
Because interest compounds on the balance, every dollar you pay above the minimum shrinks the base that future interest is charged on. The effect snowballs in your favour - the smaller the balance, the less interest accrues, the faster the rest disappears.
That is the engine behind both payoff methods in avalanche vs snowball and the reason a realistic debt-free timeline accelerates the further you get into it.