What is compound interest?
Compound interest is the interest earned from an original amount of money, plus the accumulated interest. In real terms, this means not only are you earning interest on your starting amount, but you're also earning interest on the interest it makes. Think of it a bit like a snowball effect. A snowball starts small, but the more snow that's added, the bigger it gets. As it grows, it will get bigger at a faster rate.
How does compound interest work?
Compound interest can be a very difficult thing to explain because it involves very complex formulas. But most of us don’t need to know this nitty gritty detail because a general explainer is enough to understand the value and potential dangers it can bring.
So, to keep it simple, compound interest works by adding the interest to the starting balance so, as time goes by, there’s a greater balance to earn even more interest on, leading to exponential growth over time.
To give you a hypothetical example, say you made an initial investment of £1000 and didn’t touch it for 4 years, assuming you earn 5% in annual interest, you'd earn more interest every year and at the start of year 5 it would have turned into £1,215.51
This starts to get a bit more complex to calculate when the interest gets added on a monthly basis or when you make additional contributions, but the same principle applies whereby it’s the total amount (including any new interest or contributions) that is working towards earning you more interest.
This means that as more time goes by, the higher returns you’ll see because the amount has had longer to compound. This is why it is often advised to start investing early with smaller amounts, because compound interest can take over and earn you more money than you would make by investing more at a later stage.
What are the benefits of compound interest?
Can compound interest benefit me as a saver?
Compound interest can absolutely benefit you as a saver. Any money you’re able to save will earn interest, and over time this interest will get added to your total account amount meaning you can earn even more interest moving forwards.
Once you understand compound interest, you can actually make more strategic financial decisions to benefit you even more. For example, rather than getting an account that offers annual compounding, you could look for a savings account that offers daily or monthly compounding.
Is compound interest ever a bad thing?
Taking the exact same concept and looking at debt, you can see how compound interest can sometimes be a bad thing. When you borrow money, you are charged an interest rate. The longer you wait to pay off your debt, the larger your debt can become with the added interest. Your interest repayments then become the interest on the original amount you borrowed, plus the interest on the interest your debt has accrued.