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“Earning interest on your interest”? What on earth does that mean? Well, let’s imagine you’ve just opened a savings account and have deposited a lump sum in it.
If your savings account pays interest monthly and into the account itself, your account balance will grow every month and you’ll earn interest on your interest as well as interest on your savings. At the end of the year, your savings will have grown a bit more than they would have with a savings account that only pays interest annually.
For example, say you have £5,000 in a savings account that pays 3% a year (gross). If it’s paid annually, at the end of the year you’ll have £5,150. If it’s paid every month, allowing you to take advantage of compound interest, at the end you’ll have £5,152.08.
In the graph below, we show you what happens to your savings if you put £5,000 in a savings account that pays a 5% gross yearly rate.
“Simple interest” shows how your savings would grow if you didn’t keep your interest in the same account – say, because you move it to a separate current account that doesn’t earn any interest. “Compound interest” shows you what happens if you keep the interest in the same savings account, so that you earn interest on your interest. In this example, interest is compounded monthly.
As you can see, the difference becomes more and more noticeable as years go by.
Compound interest is less a feature of your savings account than a strategy you can use to boost your savings. You can take advantage of it by constantly putting aside both your initial savings and the interest you earn on them.
However, some savings accounts will let you take advantage of compound interest automatically, while with others you’ll have to wait until they expire to get your interest, and then put the whole sum in a new account. It depends on two main factors:
Some of the savings accounts that pay the best rates (such as regular savings accounts) only pay interest upon maturity, so there isn’t any compound interest involved. Conversely, easy access savings accounts don’t normally have an expiration date, and by definition you can deposit and withdraw money when you like, so to take advantage of compound interest you just have to avoid withdrawals.
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