The concept of compound interest can sound a bit technical, but in a nutshell, it means earning interest on your interest. In the long term, it can make a significant difference to your savings as long as you let the interest payments build up in your account.
The Financial Services Compensation Scheme (FSCS) guarantees that it will step in to compensate the first £85,000 (£170,000 for a joint account) you have saved with a UK-authorised bank, building society or credit union in the event that the business goes bust.
“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 £10,000 in a savings account that pays 3% a year (gross). If it’s paid annually, at the end of the year you’ll have £10,300. If it’s paid every month, allowing you to take advantage of compound interest, at the end of a year you’ll have £10,304.16. See our compound interest calculator below to work out how much you could earn on your savings.
Bear in mind that how frequently the interest is compounded can make a big difference too: if it compounds every day then your savings will grow quicker than if it compounds every year.
But while compound interest is your friend when you’re saving, it can make be a tricky thing when you’re in debt. This is because the interest compounds to make your debt bigger, making it harder to pay it off.
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.
Use the fields above to estimate your return.
Compounding an interest rate more frequently gives you a higher annual effective rate. But bear in mind that the rate of compounding has generally already been accounted for in the AER when a bank advertises a savings product. So an account with an annual effective rate of 7.25% which compounds interest daily is actually applying around a 7% interest rate.
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 so that the interest is calculated on an ever-increasing pot.
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.
Taking advantage of the snowball effect of compound interest can be a powerful way of growing your savings.”
| Rates up to | 7.49% AER |
|---|---|
| Number of accounts | 1,445 |
| Number of brands | 123 |
| Minimum investment | £0 |
| Maximum investment | £10,000,000 |
| Opening options | Website, mobile app, branch, telephone, post |
Compound interest can be a useful strategy to help your savings grow over time. However, to really benefit you’ll need to avoid making withdrawals from your account and have the patience to let your savings grow over a number of years.
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