What is compound interest?

Compound interest is interest earned on previously earned interest. That may sound like a riddle, but it’s worth understanding, as it can significantly increase your savings over time.

Compound interest explained

The initial amount of money you put into a savings account is known as the principal. You can earn interest on this principal.

For example, if you were to put £1,000 in your savings account at an annual interest rate of 2.4% AER / Gross, you’d earn £24 (2.4% AER / Gross of £1,000) of interest in the first full year.

But in the second year the amount you’d earn would increase – even if the annual interest rate stayed the same – because compound interest starts to kick in.

So if you left your £1,024 (£1,000 principal, plus £24 interest earned in the first year) in the same savings account, you’d earn £24.58 (2.4% AER / Gross of £1,024) in the second year.

This might not seem like much of a difference, but the impact of compound interest increases over time. It’s also more pronounced when starting with a larger principal.

Compound interest example

Year
Opening balance
Yearly interest of 2.4% AER / Gross
Closing balance
1 £1,000.00

£24.00

£1,024.00

2

£1,024.00

£24.58

£1,048.58

3

£1,048.58

£25.16

£1,073.74

4

£1,073.74

£25.77

£1,099.51

5

£1,099.51

£26.39

£1,125.90

10

£1,237.94

£29.71

£1,267.65

Compound interest example

Year
1
Opening balance
£1,000.00
Yearly interest of 2.4% AER / Gross

£24.00

Closing balance

£1,024.00

Year
2
Opening balance

£1,024.00

Yearly interest of 2.4% AER / Gross

£24.58

Closing balance

£1,048.58

Year
3
Opening balance

£1,048.58

Yearly interest of 2.4% AER / Gross

£25.16

Closing balance

£1,073.74

Year
4
Opening balance

£1,073.74

Yearly interest of 2.4% AER / Gross

£25.77

Closing balance

£1,099.51

Year
5
Opening balance

£1,099.51

Yearly interest of 2.4% AER / Gross

£26.39

Closing balance

£1,125.90

Year
10
Opening balance

£1,237.94

Yearly interest of 2.4% AER / Gross

£29.71

Closing balance

£1,267.65

Taking advantage of compound interest on a savings account

The earlier you start saving, the more time you have to earn compound interest. It’s a good idea to regularly add to your savings account if you can to keep your money growing. It’s also best to avoid taking money out of your savings account as that reduces the amount of interest you’re earning. 

Compound interest on lending

Compound interest doesn’t just apply to savings. Some forms of lending may also be subject to compound interest, including some credit cards and loans – meaning you’ll owe interest on the interest you’ve previously accrued. 

What next?

There are different types of savings accounts you can explore to find the right one for your needs – from fixed rate savers to ISAs. Read our savings explained guide to find out more. 

Definitions:

AER stands for Annual Equivalent Rate. This shows you what the gross rate would be if interest were paid and compounded each year.

Gross is the rate of interest if interest were paid and not compounded each year.

This article provides general information and does not take into account the financial situation of the reader. For this reason it must not be relied on as financial advice. All accounts are subject to terms and conditions.