Confused by compound interest and how it works? We explain what it is and how it’s calculated.
Just as compound interest can accelerate the growth of your savings and investments, it can have the same effect on your debts too. We explain how it works.
In this article we cover:
- What is compound interest?
- How does compound interest work on savings and investments?
- How does compound interest work on credit card debt?
- How to calculate compound interest
- Why is compounding so powerful?
Read more: Investing for beginners course: module one
What is compound interest?
It is essentially the interest that you can earn from your interest.
Imagine a snowball rolling down a mountain. It starts the size of a small rock, but every rotation picks up a bit more snow until it is the size of a boulder when it reaches the bottom.
This is how the principle of compound interest works. The term is often used in relation to both savings and investments as well as loans and debt.
Understanding the principle, formula, and how it is calculated can make a big difference to your finances.
Over time, you earn interest on the initial sum of money saved, as well as the interest itself:
- Year 1: interest is earned on your initial deposit.
- Year 2: interest is earned on your initial deposit, plus interest earned in year 1.
- Year 3: interest is earned on your initial deposit, plus interest earned in both year 1 and year 2. This pattern continues.
This means that not only are your savings growing over time, but the rate at which they grow gets faster as well.
But remember that the same can apply to money you borrow too, with the snowball effect making your debt larger.
So you could end up with either a boulder-sized pot of cash or a boulder-sized pot debt to repay.
Read more: What do UK interest rate rises mean for you?
How does compound interest work on savings and investments?
If you are saving or investing, compound interest will increase the amount by which your money grows every year. This is because every year there is a larger sum to earn that interest.
This can only work if you invest for growth, which is when you leave your money invested for a number of years.
If you are investing for income, where you regularly skim off the interest you earn, you will not benefit from compounding.
Remember: your investments can go up as well as down. Even if you benefit from compounding at times, you could get back less than you invest. If you’re unsure about investing, seek independent financial advice.
Read more: Investing for beginners guide
How does compound interest work on credit card debt?
While compound interest is a saver’s best friend, it can be a borrower’s worst nightmare.
When you make repayments on your credit card you pay back interest on the original debt, but also on the interest that is accrued.
The average interest rate on a credit card reached a 16 year high at the end of 2022, hitting a hefty 30.3%.
Not only do you owe the original amount that you borrowed to the lender but you also have to pay a hefty interest rate on top.
Just as a small amount of savings can grow over time without you adding any more money to the pot, a small debt can also grow without you spending any more money.
It could take years to clear your debt, which is why it is important to understand how interest repayments work before taking on debt.
If you are struggling with credit card debt, we have more about consolidating debt and where to go for debt help.
Read more: Best reward credit cards
How to calculate compound interest
Compound interest is calculated using both the principal sum of money plus the interest generated over time.
There are plenty of tools online that can help you work out compound interest.
The investment platform Nutmeg has a compound interest calculator you could try to see the power of compounding over time.
Read more: Best savings accounts in 2023
What is the difference between compound interest and simple interest?
Simple interest is that which is generated on the initial amount that you saved or borrowed. It doesn’t include the interest you have earned on interest.
It’s easier to calculate than the compound interest formula.
To calculate the simple interest earned you multiply the original sum by the interest rate in order to get the amount of interest earned per year.
If you’re invested for more than a year, you multiply the figure by the number of years.
Read more: CPI vs RPI inflation: what’s the difference?
Why is compounding so powerful?
The principle of compound interest is powerful because even without adding to your initial deposit, your money will continue to grow.
Compounding will leave you better off because interest will go to work on a sum of money that has already been enhanced by a previous year’s interest.
Say you invest a lump sum of £100 and receive savings interest or market returns of 5% a year. If you were to earn simple interest, then after:
- 1 year: 5% interest on your £100 (£5) will give you a total pot of £105
- 2 years: 5% interest on £100 + (£5 interest x 2 years) = £110
- 3 years: 5% interest on £100 + (£5 x 3 years) = £115
- 10 years: 5% interest on £100 + (£5 x 10 years) = £150
- 20 years: 5% interest on £100 + (£5 x 20 years) = £200, your original £100 plus £100 in interest
If you invest the same amount, but it earns compound interest, then after:
- 1 year: 5% interest on your £100 (£5), will give you a total pot of £105
- 2 years: 5% interest on £105 (£5.25) = £110.25
- 3 years: 5% interest on £110.25 (£5.51) = £115.76
- 10 years: a total pot of £162.89, your original £100 plus £62.89 in interest
- 20 years: a total pot of £265.33, your original £100 plus £165.33 in interest
After 20 years you could have earned £165.33 in compound interest compared to £100 in simple interest.
Does the frequency of interest payments affect compound interest?
How often you are paid interest on will affect the rate at which compound interest accumulates.
If the interest period is quarterly or monthly then the amount of interest earned (or paid) over the year will be larger than if it is calculated annually.
So for example:
- 5% interest on £100 calculated annually after 20 years would give a total of £265.33
- 5% interest on £100 paid biannually after 20 years would give a total of £268.51. That’s £3.18 more in interest than you would get if it was calculated on an annual basis
- 5% interest on £100 paid every month after 20 years would give a total of £271.26. That’s £5.93 more in interest than if the interest was only calculated annually
Read more: With interest rates forecast to fall, what should I do with my savings?
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