What is the difference between simple and compound interest?

Simple interest means the amount of money increases by the same amount each year, compound interest means the amount of money increases by the same proportion each year. For example if you deposited £100 in the bank at 3% interest, you would earn £3 on your money each year as 3% of £100 is £3 and you earn the same amount each year. This means that at the end of a 3 year period you would now have £109.

If you take the same example with compound interest, if compound interest is 3% per year, your money increases by 3% each year. It is easiest to explain using the example:

Year 1: 3% of £100= £3, £100+£3=£103     Year 2: 3% of £103=£3.09, £103+£3.09=£106.09    Year 3: 3% of £106.09=£3.1827, £106.09+£3.1827=£109.2727. As the smallest value of english currency is 1p we would round this to 2 decimal places... £109.27

An easy formula for compound interest is: (original amount) × (proportion increase)^{number of years invested}= final amount

eg... 100×1.03³=109.2727.