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What Is an Interest Rate?
Simple vs. Compound: The Two Types of Interest
Calculating Interest on Your Own
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Interest rates can feel like good news or bad news depending on which side of the equation you're on. Earning a high rate on your savings? Great. Paying a high rate on an auto loan? Not so much.
Either way, understanding how interest works puts you in a better position to make smart financial decisions. Let's break it down.
What Is an Interest Rate?
In the simplest terms, an interest rate is a percentage of a given amount — called the principal — that you either earn or owe over time.
For deposit accounts like savings or checking, you earn interest on your balance. For loans and credit cards, it works the other way. With these, you owe interest to your lender based on what you've borrowed.
Worth Knowing: As a credit union, Spero refers to interest earned on deposit accounts as “dividends.” Same concept, different name.
Simple vs. Compound: The Two Types of Interest
Not all interest works the same way. There are two types: simple and compound, and when it comes to growing your money, the difference matters.
Simple interest is calculated on your principal only, the amount you originally deposited or borrowed. It doesn't change based on interest you've already earned or paid.
Here's a real-world example: say you deposit $1,000 into an account with a simple interest rate of 5.00% per year. Each year, you'd earn 5.00% of that original $1,000 — exactly $50 — year after year. After ten years, you'd have earned $500 in interest, bringing your total balance to $1,500.
Compound interest is where things get more interesting. Instead of calculating interest on your original principal only, compound interest factors in the interest you've already earned — meaning your balance grows faster over time.
So how does compound interest work, exactly? Using the same $1,000 deposit at 5.00% per year, your first year looks identical. You earn $50. But in year two, interest is calculated on $1,050 (your original deposit plus that first year's earnings), so you earn $52.50 instead. The difference seems small at first, but it adds up. After ten years, you'd have earned $628.89 in interest — nearly $129 more than with simple interest — for a total balance of $1,628.89.
Calculating Interest on Your Own
The math behind interest rates isn't too complicated, but online calculators make it even easier. Here’s one for simple interest and one for compound interest if you want to run your own numbers.
One last thing: interest rates apply to deposit accounts (i.e., savings) and loans (i.e., auto loans). You might be earning or owing interest on an amount, depending on the situation. Before opening any account or signing for any loan, make sure you understand the terms. When there’s interest involved, knowing what you're agreeing to is one of the most important financial moves you can make.
This material is for educational purposes only and is not intended to provide specific advice or recommendations for any individual.
