What is interest?
Interest is a way of generating money from money. You can earn interest from your savings or pay interest on the money you’ve borrowed.
What is compound interest?
Compound interest is the interest you earn from your original deposit combined with the interest you’ve earned so far. If you make deposits into a compound interest savings account where interest is paid annually, you’ll keep earning interest on each previous year’s interest. This means that if the rate of interest stays the same, you’ll earn more from your savings every year your interest compounds.
How does compound interest work?
Here’s a simplified example of how compound interest works:
If you deposit £2,000 into a savings account that offers a fixed interest rate of 10% and pays interest annually, you’ll earn £200 in interest on the first anniversary of opening your savings account, giving you a balance of £2,200.
If you don’t make any deposits or withdrawals during the second year, you’ll earn another 10% in interest, but this time, that 10% will be on a savings account balance of £2,200. 10% of £2,200 is £220, so that means you’ll earn £220 in interest, and your balance at the end of year two will be £2,420. You’ll have earned interest on your original deposit and also on the interest you earned in year one.
This is an overly simplified explanation of how compound interest works, as other factors affect how interest is calculated, paid and compounded, but this gives you an idea of the process. Compound interest means that the amount of interest paid on your savings will grow, even if you don’t make any more deposits. Of course, if you do make deposits, you’ll earn interest on those, too.
If the savings account you choose pays interest more than once a year, the compounding effect is greater as interest is paid more frequently. It’s always best to check how often interest is paid if you’re considering savings accounts that pay compound interest.
How do I calculate compound interest?
The formula for calculating compound interest for long-term comparisons looks complicated, but you really only need to remember how it works, as in the simplified example above.
The compound interest formula is A = P(1 + R/N)^NT, where:
- A is the total Amount you’ll earn at the end of your term
- P is the Principal, or the amount of your initial deposit
- R is the annual interest Rate you’ll earn
- N is the Number of times your interest will compound
- T is the Time in number of years you expect to save for
What are ‘compounding periods’?
A compounding period is simply the time from one interest payment to the next.
The rate of compound interest depends on how often interest is paid. If your interest period is quarterly or monthly, the total amount of interest you’ll earn at the end of one year will be higher because the interest you earn is accumulated over smaller periods of time.
What are the benefits of opening compound interest savings accounts?
The main benefit of opening compound interest savings accounts is that you can earn more from your savings quicker than you would with savings accounts that don’t compound interest. The earlier you start saving, the more you will accumulate, which is especially beneficial if saving for retirement is one of your savings goals.
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