What is compound interest?

What is compound interest?

Compound interest is interest that accrues (builds up) on an invested or borrowed amount plus any interest it accumulates over time. 

It is different from so-called simple interest, which you only earn on the initial amount invested (or borrowed).

In other words, compound interest is interest on interest, which can make savings accounts much more profitable and some forms of borrowing much more expensive when maintained for a long time.

How does compound interest work?

Over time, earning compound rather than simple interest on your savings can significantly increase your total balance. 

The difference may only seem small at first, but it will become larger and larger the longer your money stays in the account. 

And the more often interest is paid – or compounded – the greater the impact of compound interest on the account's balance.

When it comes to investments, earning compound returns – for example, by reinvesting any dividends paid out by companies to their shareholders – can also make a big difference to how much your pot is worth after a number of years.

As a saver or investor, you should seek out compound interest and returns whenever possible.

But beware: if you take out a loan that charges compound interest, you could end up paying back a lot more than you would on a simple interest deal.

Example of compound interest

Say you invest £10,000 in a savings account paying a fixed rate of 5% a year. 

After ten years of simple interest payments at £500 a year, your total investment would be worth £15,000. 

However, if you received compound interest at 5% a year, the value of your investment after ten years would be closer to £16,500. 

This is because the interest paid each year is based on the value of the investment at that time, including the interest already earned, rather than the initial amount of £10,000.

How should I calculate compound interest?

Calculating compound interest is quite complicated. 

You can do it yourself using a mathematical formula: ((A*(1+i)^n) - A), where A is the initial amount invested or borrowed; i is the annual interest rate; and n is the number of times it has been compounded (which could be daily, monthly or annually). 

But by far the simplest way to calculate compound interest is to use an online calculator designed for that purpose. 

There are various free ones available. Generally, all you need to do is enter the amount you plan to invest, the interest rate or return you expect to earn, and the time you intend to leave your money there accumulating interest. 

You may also need to enter whether the interest will be compounded every day, every month or once a year. 

Who benefits from compound interest?

Investors, savers and lenders can all benefit from compound interest as it increases their overall level of return. 

However, borrowers who pay compound interest can lose out as being charged in this way increases the total cost of repaying a loan or credit card balance.

What are the pros and cons of compounding interest?

Compound interest can work both for and against you, depending on whether you are earning it or paying it. From an investment/saving point of view, the main advantages and disadvantages of compounding interest include:

Pros

• It creates a snowball effect that allows you to maximise your returns – especially over the longer term

• It helps you to beat inflation and avoids the value of your savings eroding over time

Cons

• It’s not always easy to calculate unless you use an online calculator

• Will be subject to tax (unless you save/invest within an ISA)

How does compounding work with different products?

As explained above, compounding can work for or against you depending on whether you are earning or paying compound interest or returns.

Investing

When you invest in the stock market, you hope to make a profit thanks to the value of your investments rising.

The easiest way to benefit from compound returns as an investor is to leave any extra money made in capital growth and dividends (regular shareholder payouts) you are eligible to receive invested so that it continues to grow.

This process allows you to benefit from the cumulative effect of any gains you make during that time.

And that could make a big difference to the value of your investment after five or ten years (or more).

Borrowing

When you borrow money via an overdraft linked to your current account, you will generally start to accumulate interest on your balance immediately at the agreed interest rate.

And if you don’t pay the balance off in full, you’ll pay interest at the same rate on the interest already due.

This is why, in our current account tables, we use EARs (effective annual interest rates) that take into account the cost of compounding to help you choose the best overdraft.

Example: If you use an overdraft to borrow £500 at an EAR of 39.49%, the amount you owe in total will increase daily, meaning that after one day, you’ll owe £500.46, and after 30 days, you’ll owe £513.87. 

This snowballing debt is why it’s best to avoid borrowing with compound interest if at all possible.