This is where brain ache is likely to set in. So, we know about how interest is calculated, but compound interest works slightly differently in that it’s worked out by charging interest not just on the loan amount, but on the interest as well. In other words, it’s charging interest on your interest.
Compound interest is great if you have a savings account but not so great if you have a loan. Let’s say you had savings of £1000 and earned 5% interest in one year; after 12 months, you’d have gained £50 in interest – a total of £1,050 in your account. But in year two with compound interest, you would accrue interest not just on your capital amount (your initial £1,000) but also on the interest. So you would earn 5% of £1050 which is £52.5, a bit more than your initial £50!
When it comes to loans, compound interest is exaggerated the longer the loan period is – because you’re paying interest over more time. You should always make sure you read the terms and conditions of your loan to avoid any costly surprises.