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Compound interest

Compound interest is a phrase that you might hear when referring to savings and investments. Essentially it’s interest earned on previously earned interest.

‘What?’

It may sound a little confusing, but don’t worry! It’s actually pretty easy to understand. It’s important to know exactly what compound interest is, as it can have a massive impact on your finances over time.

Compound interest explained

When you save money, you’ll likely earn interest on your savings. Compound interest refers to the extra interest you’ll earn on top of the interest itself. 

Here’s an example:

Let’s say you put £1,000 into a savings account that had an annual interest rate of 1.5% AER/Gross. In the first full year, you’d earn £15.10 in interest. However, in the second year, the amount you’d earn would increase, even if the annual interest rate stays the same. 

Why? Because compound interest will have kicked in. Not only will your savings increase over time, but the rate at which they grow will get faster too.

Why is it useful?

Compound interest is useful because even if you don’t add to your savings, they can continue to grow, especially if they’re kept over a long period of time. This is why many financial experts and family members tell you to start saving as early as possible.

Let’s compare two situations:

  • James saves £100 a month (based on 10% annual interest) from when he’s 30, up until he’s 60. In total, James will save £217,132.11 
  • On the other hand, Alex starts saving £100 a month when they turn 20, but stops at aged 30. They leave the money in their savings account until they are 60. In total, Alex accumulates £367,090.06

That’s how useful compound interest can be. Sometimes saving for 10 years can be more worthwhile than saving for 30 years – if you start early.

Compound interest on lending

Unfortunately, compound interest doesn’t just apply to savings. Some types of lending/borrowing can also be subject to compound interest. 

For example, on some credit cards and loans, you might owe interest on the interest you’ve already accrued. In the same way that a small amount of savings can grow over time without additional deposits, a small debt can also grow unless you pay it off.

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