'Compound interest' is a phrase that is regularly used in the world of savings andinvestments andalthough its meaning may not be immediately obvious, it’s actually quite easy to understandand can havea significant effect on yourfinances. This relativelysimple concept is relevant to both your savingsand debts, and as such it is something anyone planning their financial future should lookinto.
What is compound interest?
Compound interest refers to the principle that when you save money, as well as earninginterest on thesavings, you also earn interest on the interest itself. Therefore, every year that the moneyis in youraccount you are earning interest on each previous year’s interest. This means that not onlyare yoursavingsgrowing over time, but that the rate at which they grow gets faster as well.
We can see this in action by taking some basic figures – for example, if you deposited £1000at a rate of10%, at the end of year one you would have £1100, equalling £100 of interest earned. Thefollowing yearyouwould earn £110 in interest – 10% of the original capital and 10% of the year one interest.The nextyearwould be £121 and so on.
The rate at which compound interest (or ‘compounding’ as it is sometimes known) accumulatesalso dependsonthe frequency of interest payments. If the interest period is not annual, but is insteadbi-annual orquarterly or monthly, then the total amount of interest paid across the year will be higher.This isbecauseinterest is being paid on interest accumulated in those smaller periods.
Why compound interest is powerful
The concept of compound interest is powerful because even if you do not add to your savings,they cancontinue to grow. Over a long period, this can create a huge difference and explains why,when it comesto savings advice, so many experts will tell you to start saving early.
If an individual was to start saving £100 a month at the age of 30 and continued until theywere 60, theywould have saved, with 10% annual interest, a sum of £217,132.11. However, if they startedsaving £100 amonth at the age of 20, stopped when they were 30 and left the money in the account untilthey turned60,they would have accumulated £367,090.06 The ‘magic’ of compound interest, in this example,means thatsavingfor 10 years can be more profitable than 30 years, if it starts earlier.
Although the example above is quite a simple hypothetical one, which you can replicateyourself by usingacompound interest calculator or spreadsheet; real life cases can potentially see a similareffect. Inreality there are other factors such as inflation, fluctuations in interest rates andwithdrawals/deposits, which will affect how your savings grow.
How compound interest works with credit cards
Although compound interest can provide huge benefits for savers, the concept also applies tointerestpaid on debt. When you make repayments on a credit card you will be paying back interest onthe originaldebt, but also on the interest that is accrued. In the same way that a small amount ofsavings can growover time without additional deposits, a small debt can also grow without any furtherexpenditure.
The concept of compound interest is not that complex, but it is possible to underestimatejust how bigits effect can be. This may be a pleasant surprise when your savings grow faster thanexpected, butcould mean that people taking on debt do not realise the total amount they will have to payback, ifmaking small repayments over many years.
This is why it is important that before taking on debts, you fully understand how theinterest repaymentswork and are clear on different types ofinterest rate.
Calculating compound interest
The formula for calculating compound interest is P= C (1 +r/n)nt – where ‘C’ is the initial deposit,‘r’is the interest rate, ‘n’ is how frequently interest is paid, ‘t’ is how many years themoney isinvestedand ‘P’ is the final value of your savings. If you are not that familiar with equations, youdo not needtoworry about trying to plug in all the numbers yourself, as several tools exist online thatcan do it foryou.
One tool that was linked to above is from The Calculator Site - which cancalculatecompound interestpaidon regular deposits or on a lump sum. These kinds of tools are useful for giving anindication of whatmighthappen to your savings and may help you decide how much you need to save and how often.
FAQs
Compound interest refers to the principle that when you save money, as well as earning interest on the savings, you also earn interest on the interest itself. Therefore, every year that the money is in your account you are earning interest on each previous year's interest.
What is a simple way to explain compound interest? ›
Compound interest is when you earn interest on the money you've saved and on the interest you earn along the way.
How does compound interest work in the UK? ›
Compound interest means that the amount of interest paid on your savings will grow, even if you don't make any more deposits. Of course, if you do make deposits, you'll earn interest on those, too.
What is the best explanation of compound interest? ›
Compound interest is interest calculated on both the initial principal and all of the previously accumulated interest. Generating "interest on interest" is known as the power of compound interest. Interest can be compounded on a variety of frequencies, such as daily, monthly, quarterly, or annually.
How do you answer compound interest questions? ›
The formula for compound interest is A=P(1+rn)nt, where A represents the final balance after the interest has been calculated for the time, t, in years, on a principal amount, P, at an annual interest rate, r. The number of times in the year that the interest is compounded is n.
How much is $1000 worth at the end of 2 years if the interest rate of 6% is compound? ›
Basic compound interest
For other compounding frequencies (such as monthly, weekly, or daily), prospective depositors should refer to the formula below. Hence, if a two-year savings account containing $1,000 pays a 6% interest rate compounded daily, it will grow to $1,127.49 at the end of two years.
What is simple and compound interest for dummies? ›
Simple Interest: Calculated annually on the amount you deposit or owe. Compound Interest: Interest earned is added to the principal, forming a new base on which the next round of interest is calculated. This can accrue daily, monthly, or quarterly.
How do you calculate interest in the UK? ›
To work out the amount of interest paid on your savings account, you can multiply your account balance by the interest rate you received, then the number of years your money's been in the account.
How do you calculate simple interest UK? ›
Use this formula to calculate simple interest: I = P * R * tThe formula denotes 'I' as the simple interest, 'P' as the principal amount, 'R' as the rate and 't' as time.
How do interest rates work in the UK? ›
The Bank Rate sets the amount of interest paid to commercial banks, which in turn influences the rates they charge customers for borrowing, or pay them for saving. If the Bank Rate increases: Unless your interest rates are fixed, the cost of borrowing will go up. Interest earned from savings will increase.
Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns. Let's say you have $1000 in a savings account that earns 5% in annual interest. In year one, you'd earn $50, giving you a new balance of $1050.
How do you explain simple and compound interest? ›
Simple interest is calculated on the principal, or original, amount of a loan. Compound interest is calculated on the principal amount and the accumulated interest of previous periods, and thus can be regarded as “interest on interest.”
What is compound interest in one sentence? ›
Compound interest is the interest calculated on the principal and the interest accumulated over the previous period. It is different from simple interest, where interest is not added to the principal while calculating the interest during the next period. In Mathematics, compound interest is usually denoted by C.I.
How to calculate compound interest in the UK? ›
The formula for calculating compound interest is P = C (1 + r/n)nt – where 'C' is the initial deposit, 'r' is the interest rate, 'n' is how frequently interest is paid, 't' is how many years the money is invested and 'P' is the final value of your savings.
What is the easiest way to explain compound interest? ›
Compound interest is when you add the earned interest back into your principal balance, which then earns you even more interest, compounding your returns. Let's say you have $1,000 in a savings account that earns 5% in annual interest. In year one, you'd earn $50, giving you a new balance of $1,050.
What is the trick for compound interest? ›
If a sum A is compounded annually becomes A1 in t years and A2 in (t+1) years, then the principal can be calculated using: P = A1 (A1/A2) In two years, the difference between compound interest and simple interest can be calculated using: P x (R)2/ (100)
What is compound interest explained to kids? ›
Put simply, compound interest is when you earn interest on both the money you've saved and the interest you've already earned.
