Now we need to distinguish between the “nominal interest rate” and the “real interest rate”.
The nominal interest rate is the one that is fixed when money is deposited in a bank or when a loan is credit is granted.
If you deposit 100 euros on a bank savings account and if the annual credit interest rate is 5%, your deposit will increase to 105 euros in one year. But that does not necessarily mean that the value of your deposit will be 105 euros as well. If prices have also increased by 5% over the same period, the value of your deposit does not change, you will be able to buy exactly the same amount of goods and services in a year as today. So you have gained nothing, the real interest rate amounts to 0%. However, if prices only increased by 3%, the value of the deposit increases by 2%, the real interest rate thus amounts to 2%. And when prices rise by 7%, you will get less for your saved money in a year than you get today, the value of the deposited money decreases by 2% which means that the real interest rate is negative: -2%.
Now let’s come back to the term “compound interest” mentioned above.
In general, the credit interest paid, for example, on a bank balance will be added to the amount invested (capital) and paid into the same account. The interest acquired will then generate credit interest of its own – called compound interest – , that will be added to the account, so that the deposit grows faster and faster over time.
In the same manner, compound interest makes a debt grow faster and faster, if the debtor does not repay it gradually. In practice however, a borrower repays his debt in (usually monthly) installments, so that his debt decreases over the years.
