Compound interest is one of the most important facts of financial life, and has been called the eighth wonder of the world due to its effect on finances.  It is important that a borrower has some understanding of compound interest in order to better manage their loan and their general finances.

Simple interest is when interest is charged on the original sum, but no interest is charged on the interest.  So if a person were to borrow $1,000 at 10% simple interest then they would be charged at $100 in the first year, $100 in the second year and so on.

However compound interest is when the interest is charged on the interest that has already accumulated.  Almost all loans are charged using compound interest.  In the case of $1,000 being borrowed at 10% then the first year would be charged at the same amount as with simple interest, or $100.  In the second year there would be $100 charged on the original amount and another $10 on the interest, leading to a total interest of $110.  In the third year the total interest would go up to $121.  Over time this can have a dramatic effect.

Over seven years a 10% interest loan can double in the amount outstanding under compound interest.  When the interest rate is higher then this multiplication effect is far quicker.  It is for this reason that many people can feel that they are losing control of their finances. 

The key to dealing with compound interest is to always find the highest interest rate that is being charged and to pay this interest off as far as possible, bearing in mind that some loans do not allow for overpayments and that most loans will have minimum loan repayment requirements every month.

The practice of paying off the highest interest loan first is known as snowballing, as like a snow ball rolling down a hill it picks up momentum as it picks off more and more interest.  Mathematically this will always be the method that pays off total debt fastest as more money is being used to pay off the capital rather than the interest.  However this can be a reasonably difficult method to maintain as the loan with the highest interest rate can be the largest loan and so there is not much feeling of movement with the repayment.