Explaining compound interest

'Compound interest' is a phrase that is regularly used in the world of savings and investments and although its meaning may not be immediately obvious, it’s actually quite easy to understand and can have a significant effect on your finances. This relatively simple concept is relevant to both your savings and debts, and as such it is something anyone planning their financial future should look into.

What is compound interest?

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. This means that not only are your savings growing 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 £1000 at a rate of 10%, at the end of year one you would have £1100, equalling £100 of interest earned. The following year you would earn £110 in interest – 10% of the original capital and 10% of the year one interest. The next year would be £121 and so on.

The rate at which compound interest (or ‘compounding’ as it is sometimes known) accumulates also depends on the frequency of interest payments. If the interest period is not annual, but is instead bi-annual or quarterly or monthly, then the total amount of interest paid across the year will be higher. This is because interest 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 can continue to grow. Over a long period, this can create a huge difference and explains why, when it comes to 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 they were 60, they would have saved, with 10% annual interest, a sum of £217,132.11. However, if they started saving £100 a month at the age of 20, stopped when they were 30 and left the money in the account until they turned 60, they would have accumulated £367,090.06 The ‘magic’ of compound interest, in this example, means that saving for 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 replicate yourself by using a compound interest calculator or spreadsheet; real life cases can potentially see a similar effect. In reality there are other factors such as inflation, fluctuations in interest rates and withdrawals/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 to interest paid on debt. When you make repayments on a credit card you will be paying back interest on the original debt, but also on the interest that is accrued. In the same way that a small amount of savings can grow over time without additional deposits, a small debt can also grow without any further expenditure.

The concept of compound interest is not that complex, but it is possible to underestimate just how big its effect can be. This may be a pleasant surprise when your savings grow faster than expected, but could mean that people taking on debt do not realise the total amount they will have to pay back, if making small repayments over many years.

This is why it is important that before taking on debts, you fully understand how the interest repayments work and are clear on different types of interest 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 the money is invested and ‘P’ is the final value of your savings. If you are not that familiar with equations, you do not need to worry about trying to plug in all the numbers yourself, as several tools exist online that can do it for you.

One tool that was linked to above is from The Calculator Site - which can calculate compound interest paid on regular deposits or on a lump sum. These kinds of tools are useful for giving an indication of what might happen to your savings and may help you decide how much you need to save and how often.