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.
In this video, Alistair McQueen, Head of Savings & Retirement at Aviva, discusses the magic of compound interest, what it is and how it can have the potential to accelerate the growth of your savings over a longer period of time.
The magic of compound interest and how it works | The Investing Master Plan
Transcript for video The magic of compound interest and how it works | The Investing Master Plan
Chapter 2: The magic of compound interest and how it works
This video is for educational purposes only. This should not be viewed as advice or a recommendation to invest.
In the world of investing, compound interest is something that really excites people, and for good reason.
Some claim Einstein referred to it as the eighth wonder of the world, others have called it an investor's best friend, and many simply talk about the magic of compound interest.
So what is it and what is all this fuss about?
Put simply, compound interest is the ability to earn interest on interest on interest over the life of your investment.
Over a longer period of time, it has the potential to accelerate the growth of your savings.
So long as you get a similar interest rate over the years, you'll earn more and more interest, and all you need to do is arguably sit, watch and wait.
Let's take a theoretical example, just to show you the potential power of compound interest.
I've consciously kept the numbers simple to help explain the concept.
Your situation and your numbers will likely be different.
This example also assumes no withdrawals are being taken and the money is left to grow.
So, let's imagine I invested £1000 and it grew a steady 10% each year.
Now I know that 10% is quite generous, but it keeps the maths nice and simple.
For this example, after one year, my £1000 with its 10% growth is now worth £1100.
After two years, this £1100 with a further 10% of growth is now worth £1210.
I'm slowly making progress, but as the interest on the interest on the interest builds, it's remarkable how the value of my original £1000 builds too.
After five years with constant 10% interest, my £1000 is now worth about £1600.
After 10 years, about £2600.
After 20 years, amazingly, about £6700.
In this simple example, my £1000 has grown nearly seven times, after 20 years.
The snowball effect of compound interest starts to become clear.
And that's all without me having to add a single penny beyond my original £1000.
It proves that the sooner you start investing, the more you can gain.
Even a small start beats waiting to go big with compound interest, all I've had to do is sit, watch and wait.
But don't underplay the importance of sitting, watching, and waiting.
The power of compound interest does require you to sit.
And by that I mean don't be tempted to stand up and spend that interest.
It also requires you to watch.
In my example, I suggested a constant 10% rate of interest.
Now, the world of investing is rarely as constant and as simple as that.
If you watch your investments underperforming, you may want to stand up.
You may want to take some action and it also requires you to wait.
In my example, I showed you how the power of compound interest really kicked in after 10 and 20 years.
The magic of compound interest is real, but it takes time to come to the boil, so be patient.
Want to see the magic in action? Aviva has a simple compound interest calculator and you can try it for yourself.
Just enter the amount and see how it could grow after 5 or 10 years.
There's a link in the video description.
This video is for educational purposes only. This should not be viewed as advice or recommendation to invest. Investing offers the potential for better returns than cash savings over the long term (5+ years). But there are risks — the value of your investments may go down as well as up, and you may get back less than invested.
If you want advice on investment choices, then we’d recommend speaking to a financial adviser. There may be a charge for advice.
This video is part of our wider Each chapter is designed to work alone, so you can jump in wherever you like.
Compound interest calculator
Learn how compound interest can grow your savings over time.
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 £120,000 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.
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