How Does Compound Interest Work?

For anyone looking to make a long-term investment, it’s important to understand how compound interest works – because it could make you a lot of money!

It’s also something that we’ll almost all benefit from at one time or another, and you don’t need to do anything special to do so; just have money in a bank account which pays interest.

Let’s start at the beginning; interest is the money paid to you by your bank for banking with them. Different accounts have different rates of interest – savings accounts do not necessarily have higher rates than current accounts and fixed-term accounts.

In general, the accounts which restrict access to your money for a period of time, often have the highest interest rates on the high street.

Interest is paid as a percentage of your balance, so 1% yearly interest on an account which has £1,000 in it will be £10, usually paid at the end of the year, but different investments will calculate interest at different times.

Compound interest is when you earn money on your original balance, and also the interest that you’ve earned on it, and it can help your money to grow faster. For instance, if you earn 1% interest on your £1,000 deposit in the first year of having your bank account and make £10, the next year you’ll earn 1% interest on a deposit of £1,010 and earn £10.10. The next year, you’ll earn 1% interest on a balance of £1,020.10 and earn £10.20, and so on.

As the interest you earn increases your original deposit, the interest you earn on that deposit increases – so you make a little bit more in interest every year. It might not seem like a big effect, but if you earn 3.5% yearly interest on a balance of £5,000, after ten years you’ll have £7,052 – earning almost 50% of your original deposit in interest.

It’s a high rate of growth for money that’s essentially just sitting in a bank account, easy to access, so it’s important to understand how compound interest works – and why finding the best interest rate can help your savings to grow so much.

Compound interest can be very effectively used in pensions and also Junior ISAs, as they are designed to be long-term investments.

Check out our website for the best savings rates from around the web, and other investment option which are currently available.

Eve Hooper

A retired City worker who resides in deepest rural Essex. Eve writes on personal finance for fun and to help educate other older savers.