How to Calculate Interest: Simple and Compound Interest Explained

Two Types of Interest

Interest is the cost of borrowing money (or the return on lending it). There are two main types: simple interest, which is calculated only on the original principal, and compound interest, which is calculated on the principal plus all previously earned interest. Compound interest is sometimes called "interest on interest" and is far more powerful over time.

Simple Interest Formula

I = P × R × T

• I = Interest earned
• P = Principal (initial amount)
• R = Annual interest rate (as a decimal, so 5% = 0.05)
• T = Time in years

Example

You deposit $1,000 in a savings account at 4% simple interest for 3 years.
I = $1,000 × 0.04 × 3 = $120 interest
Total: $1,000 + $120 = $1,120

Compound Interest Formula

A = P × (1 + r/n)^(n×t)

• A = Final amount (principal + interest)
• P = Principal
• r = Annual interest rate (decimal)
• n = Number of times interest compounds per year
• t = Time in years

Compounding Frequencies

Frequency	n value
Annually	1
Semi-annually	2
Quarterly	4
Monthly	12
Daily	365

Compound Interest Example

You invest $1,000 at 6% interest, compounded monthly, for 10 years.
A = $1,000 × (1 + 0.06/12)^(12×10) = $1,000 × (1.005)^120 = $1,000 × 1.8194 = $1,819.40

Compare to simple interest: $1,000 × 0.06 × 10 = $600 interest → $1,600 total. Compound interest earned $219 more with the same rate and time.

The Rule of 72

A quick mental math shortcut: divide 72 by the annual interest rate to estimate how many years it takes for money to double.

• At 6%: 72 ÷ 6 = 12 years to double
• At 8%: 72 ÷ 8 = 9 years to double
• At 12%: 72 ÷ 12 = 6 years to double

Why Compound Interest Matters for Debt

Compound interest works against you on debt. A credit card charging 20% annual interest compounding monthly on a $5,000 balance costs approximately $1,000/year just in interest if you make no payments. This is why paying down high-interest debt quickly is so important — you're fighting exponential growth.