What is compound interest?
Wouldn’t it be great if you could save more and more money every month, without doing anything extra?
Well, when it comes to your savings you can, thanks to compound interest. When you leave money in a compound interest savings account, you’ll earn more and more interest every time it’s paid.
It’s the snowball effect for your savings and it’s a great way to build your wealth over the years. We’ll break down everything you’ll need to know to take advantage of it.
How compound interest works
As we mentioned, compound interest means that you’ll earn larger and larger amounts of interest as time goes by, assuming there are no withdrawals being taken and the money is left to grow.
For example, if you start out with £1,000 in your savings and a compound interest rate of 5%, which is added annually, then at the end of the first year you’ll have £1,050. In the second year, you’ll earn interest on £1,050, which is £52.50, bringing your total to £1,102.50. With each year that passes, your interest gets bigger and bigger.
But compounding is a double-edged sword. When it comes to borrowing money, it works against you. If, instead, you have a £1,000 loan and don’t make efforts to pay it off quickly, compounding will mean that your interest payments will grow over time.
With a large loan made over a long time, like a mortgage, the amount of interest you’ll pay back can be huge, often more than you borrowed.
There’s actually a way you can work out the final amount you’ll have saved, or will owe, after compound interest. As you can see, it’s a little complicated!
A = P (1 + r/n)nt
- A: Final amount (initial amount + interest)
- P: Initial amount
- r: Annual interest rate (e.g. 5%)
- n: Number of times interest is added each year
- t: The length of time that you’re saving, in years
Don’t worry if you’re not a maths wizard, we’ve created a compound interest calculator that does the heavy lifting for you.
Benefits of compound interest in savings accounts
The magic of compound interest is that it accelerates the growth of your savings over time. As long as you get a similar interest rate, as the years go by you’ll earn more and more interest.
If you deposit £100 a month into an account with a 5% interest rate paid annually, over 10 years that will grow to £15,500 – with £3,500 coming from interest.
With simple interest, you’d have £14,975 – with £2,975 coming from interest.
Compound interest rewards consistency and patience. Starting to save early in life gives you more time to take advantage of compounding.
What’s the difference between compound interest and simple interest?
The difference between compound and simple interest is how it’s calculated over time. Compound interest grows each time it’s applied to your savings. With simple interest the amount you earn is always based on the money you’ve paid in, not any previous interest.
Simple interest may provide you with regular income from a lump sum but it’s less useful if you’re trying to grow a bigger amount over time.
Bond investments use simple interest. Over the length of the bond, you’ll get regular payments at a fixed rate of interest (also known as coupon payments). Then, at the end of the term, you get the initial amount you invested back.
Frequency of compounding
With compounding, how often you receive interest makes a difference. The more times a year interest is received, the more times further interest is calculated on your growing balance. Here’s an example:
If you start with £1,000 and get a fixed interest rate of 5% annually, here's what you'd end up with after 10 years.
- Interest paid annually, compounded once per year. £1,628.89.
- Interest paid monthly, compounded 12 times per year. £1,647.01.
The differences are small but with a larger amount saved and more time, you can see how you could earn more interest, with just one simple change.
Comparing compound interest accounts
When you’re trying to find the best compound interest account for you, there are a few things you can check to compare them:
Interest rate
The annual equivalent rate (AER) shows the return on your savings and accounts for compound interest. A higher AER means better returns, and better compounding. You should also check whether the account has fixed or variable interest, as if your interest rate drops, it will reduce the impact of your compounding.
When interest is applied
As we saw earlier, accounts that compound monthly, rather than annually can earn you more interest. The difference is small, but over time it can mean more money in your savings.
Fees
Most savings accounts in the UK don’t have fees, but it’s best to check there are no hidden withdrawal charges or management costs that will eat into your returns.
Rules and restrictions
Some savings accounts, like cash ISAs, will have rules on how much you can pay in. Others, like notice accounts, will have restrictions on when you can withdraw your money.
Choosing the right account for you
When it’s time to pick an account, you can look at the points above and then match the accounts you find with your savings goals.
Length of time
If you’re planning to save for a short time, choose accounts with flexibility, like easy access savings accounts. For medium-term goals of up to five years, a fixed term account can provide higher returns, as locking your money away for six months or more can mean higher interest rates. But, if you’re looking at putting money away for more than five years, you may want to consider investing instead, using something like a stocks and shares ISA, or even a pension if it’s for your retirement.
When it comes to something like a pension, someone starting in their 20s will need to pay in much less than someone in their 40s to receive the same amount on retirement - if they save or invest in the same way.
If you’d like to check how this works, you can play with some figures in our pension calculator.
Risks
Most savings options are lower risk, with savings accounts and cash ISAs protected up to £85,000 per banking group by the Financial Services Compensation Scheme (FSCS). Note that inflation will reduce the buying power of your money over time, especially if the interest rate you're getting on your savings is less than the rate of inflation.
If you’re happy to accept higher risk then you could look at long-term growth investments inside a stocks and shares ISA or pension – which use compounding by reinvesting dividends you earn. You should be aware the value of investments can fall as well as rise, and you may get back less than you’ve invested.
If you’d like more information we have a helpful article on choosing the right savings account.
Related articles
