Investing might sound complicated, but you don't need to be wealthy or have a finance degree. Understanding compound interest can be your first step to making your money grow. So, what is compound interest exactly?

Compound interest is when you earn interest on your money and then earn more on that previously accumulated interest. Compound interest builds faster than simple interest, which is only interest paid on your original amount (the invested sum). Think of it like a snowball rolling downhill – it grows bigger the longer it rolls.

How Does Compound Interest Work?

Imagine you are putting money into a savings account. You start with an initial principal amount – say £1,000. At the end of the first year, you will earn interest on that initial deposit. If your account has an annual interest rate of 5%, your interest earned after one year is £50.

In the second year, interest payments aren't just calculated on your original amount of £1,000. Instead, your interest is calculated on £1,050 – the original principal amount plus the previously accumulated interest. This means your total accumulated value increases faster each year.

Compound interest can be compounded annually, monthly or even daily – the compounding frequency matters. The more often interest is calculated, the quicker your savings grow.

Calculating Compound Interest

You don't need to memorise the compound interest formula. There are several tools and online calculators that help calculate compound interest quickly. You just input your initial investment, the interest rate and the compounding periods. These calculators instantly show you the future value of your savings.

The same formula applies if you are making monthly deposits or, in other words, regular contributions to your savings account. You will see your money growing faster as the months pass. This makes visualising how your small monthly deposits can lead to a large final amount easy.

Real-Life Example: Taking Advantage of Compound Interest

Let's look at a simple example to illustrate clearly:

  • Suppose you invest an initial principal amount of £2,000 into a savings account.
  • The annual interest rate is 4%, compounded monthly.
  • Monthly compounding means interest is added 12 times a year, causing your savings to grow quicker than annual compounding.

After one year, your £2,000 would grow to approximately £2,081.45, compared to £2,080 with annual compounding. Over several years, the difference becomes more significant, thanks to compounding frequency.

Making Compound Interest Work for You

To earn compound interest effectively, follow these simple tips:

  • Start saving early. The sooner you put your initial deposit into an account, the more time your money has to grow.
  • Choose a savings account with a competitive annual equivalent rate (AER). A higher interest rate means more interest accumulated over time.
  • Consider accounts offering tax-free interest, like ISAs, where you won't need to pay tax on interest payments.
  • Stay consistent. Given time, even small monthly deposits will grow to build up a significant value of investments.

Compound Interest and Debt

Compound interest is not just for savings; it also applies to debt. Credit cards, in particular, often capitalise interest, meaning your original amount owed can quickly grow if you don't make regular payments.

Understanding how interest is calculated on your debt can help you manage it better and avoid paying excessive interest over time.

Start Saving Today

Compound interest makes your money work harder for you, increasing your savings without any extra effort. You don't have to be wealthy to start. By simply understanding and taking advantage of compound interest, you can watch your savings grow substantially over time.