What is compound interest?

Understanding compound interest and how it works.

Compound interest is a very common concept in the world of finance, and refers to the interest on savings being applied based on the initial sum as well as the accumulated interest from previous periods. It can be thought of as earning interest on interest, meaning a pot of money can grow quicker than with standard interest.

The rate of interest accrued depends on the period set, whether that’s annual, quarterly, or monthly, for example. Naturally, with a more frequent interest period, such as every month, the amount accumulated would go up faster, earning more money more rapidly.

Key takeaways from this section:

  • Compound interest on savings is worked out based on the initial deposit plus all the interest already accumulated.
  • The rate of compounding depends on the frequency of the period, such as monthly or annually.
  • Make the most of compound interest by saving early and leaving the amount untouched for as long as possible
  • Compound interest can work against you when borrowing, such as debt quickly building up on a credit card when the full amount isn’t paid off.

Compound interest explained

As an individual saver or an investor, compound interest can work in your favour if you know how to make the most of it. Compound interest can help savings and investments grow very successfully, and even protect against wealth-eroding factors such as inflation and increases in the cost of living.

Keep in mind that it can also work against you when it comes to borrowing money, such as a credit card that makes use of compound interest for monthly repayments. With interest on a debt compounding every month, it would very quickly increase the overall amount owed.

To really make the most of compound interest to grow your money, you need to start saving early and leave it untouched for as long as possible. Compound interest can keep a pot of money growing exponentially even if you don’t make another deposit, but it needs the time to really build up a substantial return.

This is what makes compound interest so powerful, as you can build up savings without needing to add to it beyond the initial deposit.

How compound interest works

To put the concept of compound interest into practice, if you had £1000 in a bank account with an interest rate of 10%, after a year you would accumulate £100 of interest. In the next year, you would then earn £110 of interest, based on the initial deposit of £1000 plus 10% of the interest you earned on it.

The power of compound interest can be shown even more effectively if we think about it in terms of saving over a long period. If you set up a savings account at the age of 30 and put aside £50 a month, with 10% annual interest you’d have £104,015 by the time you turned 60.

If you started this even earlier and saved £50 a month from the age of 20 to 30, and then just left the money untouched until you turned 60, you’d have the much greater sum of £176,640. Starting early and putting money aside for less time can actually earn you more in the long run with compound interest, so long as you give it sufficient time for the money to build.

The formula for compound interest

To work out compound interest, the formula is P = C (1 + r/n)nt . C is the initial deposit, r is the interest rate, n is how frequently interest is paid, and t is how many years the money is invested. P represents the resulting value of your savings.

Thankfully there are plenty of compound interest calculators to be found online, so it’s fairly straightforward to get an idea of what you could earn on your savings.

The rule of 72

The rule of 72 is a method of quickly making an estimate of how long it would take to double your money when investing with compound interest. To do this you need to multiply the number of years by the interest rate to try and get 72. Or rather you divide 72 by the interest rate to see how many years it would take to double your money.

For example, if you have £1000 and an annual interest rate of 5%, you divide 72 by 5 to give you 14.4, meaning it will take roughly 14 and a half years to double your money.

Compound interest FAQ's

Why is compound interest so powerful?

Compound interest can be so powerful because it effectively fuels its own growth. A savings fund will keep growing exponentially even if you never add more funds to it after the initial deposit, as each interest period paid includes interest on all the previous periods as well as the initial sum.

Can compound interest make you rich?

Compound interest can be an effective way to grow wealth, as the interest is earned on top of interest already earned. Naturally the amount you grow will depend on the initial sum invested and the length of time the fund has to grow, as well as the interest rate and the frequency of interest periods

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