Compare savings accounts with compound interest

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.

Is my money safe?

The Financial Services Compensation Scheme (FSCS) guarantees that it will step in to compensate the first £120,000 you have saved with a UK-authorised bank, building society or credit union in the event that the business goes bust.

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 into 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.

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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.

Compound savings calculator

Compounding an interest rate more frequently gives you a higher annual equivalent 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 equivalent rate of 7.25% which compounds interest daily is actually applying around a 7% interest rate.

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 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:

• 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. Instead, you should 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. You can compare savings accounts by interest rate here.

Pros and cons of a savings account with compound interest

An overview of our savings accounts with compound interest comparison

Bottom line

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.

Frequently asked questions

• What's the difference between AER and compound interest?

  AER stands for annual equivalent rate and tells you how much your savings account will earn in a year if you deposit a lump sum at the time of opening and don’t touch it for 12 months. Unlike the gross rate, the AER takes compound interest into account (if the savings account you’re looking at offers it).

• Which rate should I look at when comparing savings accounts?

  Using AER is the easiest way of comparing savings accounts. Whether your account pays compound interest or not, AER will tell you how much you’ll have earned at the end of the year.

• Are my interest earnings taxed?

  If your savings account is an ISA then you won’t be taxed on the interest you earn. But if you use a non-ISA savings account, you will only be taxed if your interest exceeds your personal savings allowance. This is £1,000 a year for basic-rate taxpayers, £500 for higher-rate taxpayers, and top taxpayers don’t get an allowance at all.

To make sure you get accurate and helpful information, this guide has been reviewed by Katherine Denham, a member of Finder's Editorial Review Board.

Written by

Valentina Cipriani

Writer

Valentina Cipriani was a writer at Finder UK. She wrote news, features and guides about banking and credit cards, helping people to improve their financial lives. She holds an MA in International Journalism. See full bio