Compound interest for savings accounts

Earning interest on your interest is an easy way of boosting your savings.

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The concept of compound interest can sound a bit technical and confusing, but in a nutshell, it means earning interest on your interest. In the long term, it can make a significant difference for your savings – as long as you keep putting aside both your savings and your interest.

What is compound interest?

“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.

Simple vs compound interest

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.

How does compound interest affect my savings account?

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:

  • How often interest is paid against your account’s time limit. For example, if you have a one-year fixed rate account that pays interest annually, you won’t be able to take advantage of compound interest. You will if interest is paid monthly instead, or if it’s paid annually but your fixed-rate account lasts more than one year.
  • Whether interest is paid into the same savings account. Some savings accounts give you the choice between having your interest paid into the account itself or into your current account. If you want to take advantage of compound interest, you need to have it paid into the savings account itself.

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.

How to make the most of compound interest

  • See the long term picture. At the beginning, the extra money you can earn thanks to compound interest will be practically negligible. It will only make an actual difference over the course of a few years, as your savings grow.
  • Reinvest both your savings and your interest. Even if your savings account deal only lasts one year and pays interest upon maturity, there is nothing stopping you from taking advantage of compound interest on a year-to-year basis. At the end of the deal, open another savings account and deposit both your initial savings and the interest you’ve earned on it.
  • Avoid withdrawals. This is actually good savings practice in general. Don’t touch your savings if you can avoid it. You should rather have a separate emergency fund you can dip into every now and then.
  • Don’t let compound interest stop you from hunting for great rates. As we said, top-paying savings accounts often only pay interest at maturity. However, a great rate will usually make a much bigger difference than compound interest, so you should still go for it. Once the introductory deal is over, just remember to compare accounts again and reinvest both your savings and any interest you’ve earned if you can.

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