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Compound interest

What is compound interest?

Compound interest could give your savings a boost. Here are some key things to remember.

Compound interest explained

Interest is like a reward for putting money in a savings account. It shows what your savings might earn, as a percentage.

‘Compound’ interest may sound a bit tricky. But it’s just a specific type of interest. It’s interest that is paid on your original savings deposit – plus any interest you’ve already earned from past years.

It could help your savings grow over time, even if you don’t add anything to them.

You can think of compound interest as a snowball rolling down a hill, with new interest added to previous interest as time goes on. The more times interest is paid, the bigger it gets.

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How does compound interest work?

You may see the effects of compound interest on a savings account within a couple of years.

Here’s how it could work if interest was fixed and paid annually:

  • First year. You’d earn interest on your original savings deposit.
  • Second year. Interest would be paid on both your original deposit, and the interest from the first year.
  • Third year. You’d now get interest on the original deposit, plus the combined interest from years one and two.
  • Fourth year. You guessed it. Interest would be paid on your original savings, along with the interest from the previous three years.

This is just an example, of course. It’s worth remembering that interest rates may change over time. And not all savings accounts pay interest annually.

What’s the difference between compound interest and simple interest?

As the name suggests, ‘simple’ interest is a bit more basic than compound interest. It’s used to work out the interest earned on your original savings deposit only. It doesn’t include any previous interest payments.

But compound interest is paid on both your original balance and any interest you’ve already earned on it. For that reason, it could be higher than simple interest.

How to calculate compound interest

Working out compound interest involves a few sums. You’ll need to include the:

  • Original savings deposit
  • Interest rate
  • Frequency of interest payments
  • Time the money will be saved for.

To make things easier, you’ll find a range of compound interest calculators online.

You can also see the effects of compounding using an interest rate called the AER. Short for Annual Equivalent Rate, this is listed on many savings accounts. It shows the interest you could earn over a year once compounding is included.

Pros and cons of compound interest

Pros

  • Helps to build returns over time. You could earn more by leaving your savings untouched and compounding interest.
  • Rewards early saving. Compound interest can gain momentum as the years go on, boosting long-term savers.
  • Tools can offer support. Online calculators and AER comparisons can make it easier to understand an account with compound interest.
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Cons

  • Higher borrowing costs. Compound interest on a credit card might make repayments more expensive.
  • Hard to work out. The sums might be tricky when calculating the compound interest for each savings account.
  • Tax may be due. Depending on your circumstances, you might need to pay tax on savings interest.
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