When you borrow money, you are required to pay interest to the lender, which is a percentage of money in addition to the original (or “principal”) amount. Types of interest include capitalized, accrued, simple, and compounded.
How does simple interest work?
Consider an auto loan that has a $1,000 principal balance, an annual simple interest rate of 5%, and a repayment schedule of 12 months. With simple interest, your payments apply to the interest first and then to the principal. This means that you never have to pay interest on interest.
How does compound interest work?
Now consider a personal loan that has a $1,000 principal balance with an annual compound interest rate of 5% with repayment in full due after one year. With compound interest, the interest accrues throughout the life of the loan.