How Interest Works on Debt

If you’ve ever looked at your loan statement and thought, “Wait, why do I still owe this much?” — you’re not alone. Interest is the reason debt can feel like it’s barely shrinking, even when you’re making payments every month. The good news is that once you understand how interest works, you can make smarter choices that save you real money.

What Is Interest, Exactly?

Interest is the cost of borrowing money. When a lender gives you money — whether it’s a credit card company, a bank, or a student loan servicer — they charge you a fee for using their funds. That fee is interest.

Think of it like renting money. Just like you’d pay rent to live in an apartment, you pay interest to use someone else’s money. The longer you borrow it and the more you borrow, the more interest you pay.

Simple Interest: The Straightforward Version

Simple interest is calculated only on the original amount you borrowed, called the principal. It doesn’t change over time based on what you owe — it’s always tied to that starting number.

Here’s the formula:

Interest = Principal x Rate x Time

For example, say you borrow $5,000 at a 6% annual interest rate for 3 years. Your simple interest would be:

$5,000 x 0.06 x 3 = $900

So you’d pay back $5,900 total. Simple interest is common with auto loans and some personal loans. It’s predictable, which makes it easier to plan around.

Compound Interest: Where Things Get Tricky

Compound interest is calculated on your principal plus any interest that has already been added to your balance. In other words, you’re paying interest on interest.

This is the type of interest that works against you with credit cards and many other debts. Here’s how it plays out:

Say you owe $5,000 on a credit card at 20% annual interest, compounded monthly. In month one, you’re charged interest on $5,000. But in month two, you’re charged interest on $5,000 plus last month’s interest. Each month, the number you’re being charged interest on gets a little bigger.

Over a year, that 20% annual rate compounded monthly actually costs you more than a flat 20% would. That’s the power of compounding — and when you’re in debt, it’s working against you.

How Monthly Accrual Works

Most lenders calculate interest on a daily or monthly basis, not annually. Here’s how monthly accrual typically works:

1. Take your annual interest rate and divide it by 12. That gives you your monthly rate.
2. Multiply your current balance by that monthly rate.
3. That amount gets added to what you owe.

For example, with a $3,000 balance at 18% annual interest:

• Monthly rate: 18% / 12 = 1.5%
• First month’s interest: $3,000 x 0.015 = $45

If you only make a $50 minimum payment, just $5 goes toward your actual balance. The rest covers interest. That’s why minimum payments can keep you in debt for years — or even decades.

Why This Matters for Your Debt Payoff

Understanding interest gives you a real advantage. Here’s what it means in practice:

• Higher balances cost more. The bigger your balance, the more interest you’re charged each month. Paying down even a little extra shrinks your interest charges going forward.
• Higher rates hurt more. A $5,000 balance at 24% costs you way more than the same balance at 12%. Targeting your highest-rate debts first can save you the most money over time.
• Time is a factor. The longer you carry a balance, the more interest piles up. Paying off debt faster — even by small amounts — reduces the total you’ll pay.

How to Use This Knowledge

Now that you understand the basics, here are a few things you can do:

• Check your interest rates. Look at every debt you have and write down the rate. You might be surprised by how much they vary.
• Pay more than the minimum. Even $20 or $50 extra per month can make a meaningful difference over time.
• Consider targeting high-interest debt first. This approach, sometimes called the avalanche method, saves you the most in interest charges.

Bottom Line

Interest is the price you pay to borrow money, and it’s the biggest reason debt can feel so hard to escape. Simple interest charges you based on your original balance, while compound interest charges you on your growing balance — including past interest. Understanding how your interest is calculated puts you in a stronger position to pay off debt faster and spend less doing it.