How does interest rate work?
Oct 24, 2023 By Edward Weston

Almost every financial service provided by banks involves interest rates. Interest rates can be fixed or variable. Basically, there are two kinds of interest rates: simple interest and compound interest. Simple interest, as the name suggests, is very simple. Suppose you have AUD $1000 in your saving account at an annual interest rate of 1% for five continuous years. After five years, you'll get AUD $1050, that means AUD $10 (1% of $1000), for five continuous years.

But the problem is that most banks use compound interest, which means that every time they pay interest (usually by month) at the cumulative total amount, not just the principal (or initial amount). In the above example, the interest AUD $0.83 will be paid in the first month, the interest of the next month will be calculated based on the principal of AUD $1000.83 (instead of the original AUD $1000). Five years later, you'll get AUD $1051.25.

Basically, compound interest is growing at a slightly faster speed, both for profit and debt.