Top of main content

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 £1,144.44 £17.29 £1,161.73

Compound interest example

Year 1 1
Opening balance £1,000.00 £1,000.00
Yearly interest of 1.5% AER / Gross £15.10 £15.10
Closing balance £1,015.10 £1,015.10
Year 2 2
Opening balance £1,015.10 £1,015.10
Yearly interest of 1.5% AER / Gross £15.33 £15.33
Closing balance £1,030.44 £1,030.44
Year 3 3
Opening balance £1,030.44 £1,030.44
Yearly interest of 1.5% AER / Gross £15.56 £15.56
Closing balance £1,046.00 £1,046.00
Year 4 4
Opening balance £1,046.00 £1,046.00
Yearly interest of 1.5% AER / Gross £15.80 £15.80
Closing balance £1,061.80 £1,061.80
Year 5 5
Opening balance £1,061.80 £1,061.80
Yearly interest of 1.5% AER / Gross £16.04 £16.04
Closing balance £1,077.83 £1,077.83
Year 10 10
Opening balance £1,144.44 £1,144.44
Yearly interest of 1.5% AER / Gross £17.29 £17.29
Closing balance £1,161.73 £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.

Explore: ISAs or savings accounts

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 Total amount added yearly Yearly interest of 1.5% AER / Gross Closing balance
1 £1,000.00 £240 £17.06 £1,257.06
2 £1,257.06 £240 £20.95 £1,518.01
3 £1,518.01 £240 £24.89 £1,782.89
4 £1,782.89 £240 £28.89 £2,051.78
5 £2,051.78 £240 £32.95 £2,324.73
10 £3,458.37 £240 £54.19 £3,752.57

Compound interest example

Year 1 1
Opening balance £1,000.00 £1,000.00
Total amount added yearly £240 £240
Yearly interest of 1.5% AER / Gross £17.06 £17.06
Closing balance £1,257.06 £1,257.06
Year 2 2
Opening balance £1,257.06 £1,257.06
Total amount added yearly £240 £240
Yearly interest of 1.5% AER / Gross £20.95 £20.95
Closing balance £1,518.01 £1,518.01
Year 3 3
Opening balance £1,518.01 £1,518.01
Total amount added yearly £240 £240
Yearly interest of 1.5% AER / Gross £24.89 £24.89
Closing balance £1,782.89 £1,782.89
Year 4 4
Opening balance £1,782.89 £1,782.89
Total amount added yearly £240 £240
Yearly interest of 1.5% AER / Gross £28.89 £28.89
Closing balance £2,051.78 £2,051.78
Year 5 5
Opening balance £2,051.78 £2,051.78
Total amount added yearly £240 £240
Yearly interest of 1.5% AER / Gross £32.95 £32.95
Closing balance £2,324.73 £2,324.73
Year 10 10
Opening balance £3,458.37 £3,458.37
Total amount added yearly £240 £240
Yearly interest of 1.5% AER / Gross £54.19 £54.19
Closing balance £3,752.57 £3,752.57

If you can, it's best to avoid taking money out of your savings account as that reduces the amount of interest you can earn.

Explore: Fixed rate vs variable rate savings accounts

How compounding works on investments

When thinking about how much your money could earn, remember to also factor in inflation. As time goes by, inflation can reduce the total value of your savings because you’ll be able to buy less with the money.

If you want to find a way to potentially beat inflation, you might want to consider investing. With investing, you don’t earn interest. Instead, you’re aiming to get a return on the money you invest. The effect of compounding over time means you could get a return not just on the initial amount you invest, but also on your earnings.

Keep in mind that with investing there are no guarantees, and there’s a chance you may not get back what you put in.

You should always plan to invest for 5 years or more to give your money more time to recover from any market dips. However, your money’s not locked away – it can be accessed at any time.

To see how much your money could be worth in years to come, under different market conditions, try our investment calculator.

Explore: New to investing?

Compound interest on lending

Compound interest doesn’t just apply to growing your money. 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. 

Explore: How to repay debts

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.