What is Compound Interest?

Compound interest is a powerful financial tool that could transform your savings.

It works by allowing you to earn interest not only on your initial deposit into your savings account, but also on any interest you’ve accumulated over time. It’s a great way to rack up earnings. Pretty decent, right?

This seemingly simple concept has the potential to significantly grow your wealth, making it a nifty tool for anyone looking to build long-term financial security. Here, let us explain.

The basics of compound interest

We all know that when you put money into a savings account it usually earns interest. But with compound interest, not only does your initial deposit earn interest, but the interest itself also earns interest (prize for whoever can guess how many times we used the word ‘interest’ there…).

It’s all about your money growing faster because, each time interest is added, it gives you more to earn on next time. Essentially, the longer you leave your money to just sit there and grow, the larger it’s likely to become. Here, let us show you an example...

Imagine you deposit £1,000 into a savings account that pays 10% interest compounded annually:

• Year 1: You earn 10% of £1,000, which is £100 in interest. Your total balance is now £1,100. 
• Year 2: You still earn 10% but now of £1,100, which gives you £110 in interest. Your total balance is now £1,210. 
• Year 3: Again, you earn 10% but now of £1,210, which is £121 in interest. Your total balance is now £1,331.  And so on.

And, compare that to simple interest:

• Year 1: You earn 10% of £1,000, which is £100 in interest. Your total balance is now £1,100. 
• Year 2: You still earn 10% on £1,000, which is another £100 in interest. Your total balance is now £1,200. 
• Year 3: Again, you earn 10% on your £1,000, so another £100 in interest. Your total balance is now £1,300. 

It’s worth noting that, while your deposit will grow with compound interest, it may not keep pace with inflation – so the actual spending power of that money could reduce over time.

Imagine a snowball rolling down a hill, getting bigger and bigger over time and you’re pretty close when it comes to compound interest.

Why should I care about compound interest?

Understanding compound interest and making it a cornerstone of your savings planning could have a positive impact on your financial wellbeing.

It’s a simple yet powerful tool that, depending on how much you save and for how long, could boost your savings over time. All with minimal effort. We call that a win-win.

By allowing your money to grow faster through compound interest, you’re better prepared to save for future expenses like buying a home, achieving your retirement dreams, or other long-term goals.

Plus, making the most of compound interest could provide a cushion for unexpected events (like the car or washing machine breaking down, for example) – helping you make sure that you have the right resources at hand to navigate life's ups and down.

MoneyHelper – a free and impartial government service offering guidance about your pension – has a savings calculator. It could help you work out how long it could take you to save for something (and how much you’ll need to save for it).

How to make the most of compound interest

Here are a handful of steps to help you make the most of compound interest:

• Start early: Save as soon as possible, and in a way that your financial situation allows for. Don’t worry, starting small helps, too.
• Contribute regularly: Maintain consistent contributions (however small) to your savings for long-term wins.
• Be patient: Remember, long-term saving is a marathon, not a sprint.

Do all savings accounts offer compound interest?

No, not all savings accounts offer compound interest. Some accounts might provide simple interest, where you earn interest only on your initial deposit.

Compound interest is more commonly offered by savings accounts, but it's important to check the terms of the specific account you're considering. Always read and research the account details to understand how interest is calculated – and whether it works for you.

Are there any cons to compound interest?

Savings accounts that offer compound interest aren’t ideal for short-term goals – simply, they perform better in the long-term.

If you’re looking for accounts with quick returns, there might be other options that are more suitable for you.

Plus, as with all savings account, unless the rate of interest matches or exceeds the rate of inflation the spending power of your money will be reduced.

So, whether you’re building an emergency fund or planning for retirement, compound interest could help finance a future where you can thrive.