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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

You can earn interest on the money you put into a savings account.

For example, if you were to put £1,000 in your savings account at an annual interest rate of 1.5% AER / Gross, you’d earn £15.10 (1.5% 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.

Compound interest example
Year
Opening balance
Yearly interest of 1.5% AER / Gross
Closing balance
1 £1,000.00

£15.10

£1,015.10

2

£1,015.10

£15.33

£1,030.44

3

£1,030.44

£15.56

£1,046.00

4

£1,046.00

£15.80

£1,061.80

5

£1,061.80

£16.04

£1,077.83

10

£1,444.44

£17.29

£1,161.73

Compound interest example
Year
1
Opening balance
£1,000.00
Yearly interest of 1.5% AER / Gross

£15.10

Closing balance

£1,015.10

Year
2
Opening balance

£1,015.10

Yearly interest of 1.5% AER / Gross

£15.33

Closing balance

£1,030.44

Year
3
Opening balance

£1,030.44

Yearly interest of 1.5% AER / Gross

£15.56

Closing balance

£1,046.00

Year
4
Opening balance

£1,046.00

Yearly interest of 1.5% AER / Gross

£15.80

Closing balance

£1,061.80

Year
5
Opening balance

£1,061.80

Yearly interest of 1.5% AER / Gross

£16.04

Closing balance

£1,077.83

Year
10
Opening balance

£1,444.44

Yearly interest of 1.5% AER / Gross

£17.29

Closing balance

£1,161.73

So if you left your £1,015.10 (£1,000, plus £15.10 interest earned in the first year) in the same savings account, you’d earn £15.33 (1.5% AER / Gross of £1,015.10) in the second year.

This might not seem like much of a difference, but the impact of compound interest increases over time. This impact is even greater when starting with a larger amount.

Taking advantage of compound interest on a savings account

The earlier you start saving, the more time you have to earn compound interest. If you can, it’s a good idea to regularly add to your savings account to keep your money growing. For example, if you added £20 a month to that initial £1,000 deposit with an annual interest rate of 1.5% AER / Gross, you'd have:

Compound interest example
Year Opening balance Yearly interest of 1.5% AER / Gross Closing balance
1 £1,000.00 £17.06 £1,257.06
2 £1,257.06 £20.95 £1,518.01
3 £1,518.01 £24.89 £1,782.89
4 £1,782.89 £28.89 £2,051.78
5 £2,051.78 £32.95 £2,324.73
10 £3,458.37 £54.19 £3,752.57
Compound interest example
Year 1
Opening balance £1,000.00
Yearly interest of 1.5% AER / Gross £17.06
Closing balance £1,257.06
Year 2
Opening balance £1,257.06
Yearly interest of 1.5% AER / Gross £20.95
Closing balance £1,518.01
Year 3
Opening balance £1,518.01
Yearly interest of 1.5% AER / Gross £24.89
Closing balance £1,782.89
Year 4
Opening balance £1,782.89
Yearly interest of 1.5% AER / Gross £28.89
Closing balance £2,051.78
Year 5
Opening balance £2,051.78
Yearly interest of 1.5% AER / Gross £32.95
Closing balance £2,324.73
Year 10
Opening balance £3,458.37
Yearly interest of 1.5% AER / Gross £54.19
Closing balance £3,752.57

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 to achieve your goals. Read our savings explained guide to find out more. 

Definitions

AER stands for Annual Equivalent Rate. This shows how much interest you’ll earn if you keep your savings in the account for a full year. All banks and building societies show their interest rate as AER, which can help make it easier when comparing savings accounts. 

Gross shows the rate of interest you’d earn before any tax has been deducted. Basic rate taxpayers (20%) have a Personal Savings Allowance of £1,000 – meaning they don’t need to pay tax on any interest earned up to this limit. Higher rate tax payers (40%) can earn £500 in tax-free interest per year. Additional rate taxpayers (45%) have no tax exempt savings allowance. The value of any tax benefits depends upon your individual circumstances. Tax rules may change in future.

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.

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