Stocks and shares ISA compound interest

Not only do stocks and shares ISAs have the advantage of all returns being tax free but, if you reinvest any interest or dividends you earn from your investments, you’ll benefit from an effect known as compounding. We outline how stocks and shares ISA compound interest works and how it can benefit you.

What is compound interest?

Put simply, it’s interest on the interest that you’ve already earned.

Let’s take a simplified example (that assumes no tax is payable on the interest you earn). Imagine that you put £1,000 into a cash savings account paying an annual 5% interest rate. At the end of the first year, you’d have £1,050 – your initial £1,000 deposit, plus £50 of interest.

Assuming you make no withdrawals, the next year you’d earn interest on the full £1,050 – totalling £52.50. The next year you’d have £1,102.50 to earn interest on, and so on.

With simple interest, on the other hand, you’d only ever earn interest on your initial deposit of £1,000 (£50 interest a year).

The cumulative effect of compound interest may not initially seem all that great, but – as our worked example, below, shows – over time it can really add up.

Which investments pay compound interest?

While interest is more commonly associated with cash savings, and investments with capital growth, there are some investments that pay a form of interest too. These include:

• Bonds. Issued by either companies (corporate bonds) or the government (government bonds, or “gilts”), with this type of investment you essentially lend your money to the bond issuer. In exchange, it will pay you an agreed amount of interest for a fixed amount of time.
• Bond ETFs. These are a form of exchange traded fund that invest in a selection of bonds, often tracking a bond index. Bond ETFs give you exposure to a number of bonds without having to invest in each one individually.
• Dividend-paying stocks and shares. Technically, the income you receive isn’t “interest” as such, and may vary from one dividend to another, but if you reinvest the dividend income it works in the same way as compound interest.

In addition, many trading platforms now pay interest on uninvested cash held in a stocks and shares ISA. And because it’s an ISA, that interest isn’t subject to tax.

Does a stocks and shares ISA earn compound interest?

That depends on what investments you hold in your stocks and shares ISA. If you hold assets that pay interest or dividends, and choose to reinvest these rather than withdrawing them, then you will earn compound interest. OR, your account provider might pay interest on you uninvested funds, and that interest can compound.

How does compounding work on a stocks and shares ISA?

Investing within a stocks and shares ISA has a big perk compared with a general investment account, and that’s because you don’t pay any tax on your returns.

If you earned interest or dividends within a general investment account that exceeded your annual allowances for these, you’d have to pay tax. This would eat into the income you received and the amount you had left to reinvest to earn compound interest. The tax rate depends on the type of income (interest or dividends) and whether you’re a basic or higher-rate taxpayer.

But with a stocks and shares ISA, there’s no tax to pay, so the compounding effect will benefit you even more. Nice, eh?

How often do stocks and shares ISAs compound?

It depends on the investment. Some pay interest (or dividends) annually, adding on the appropriate amount at the end of each year. In this case, you’ll have a whole year to wait before you earn interest on interest.

However, some investments pay interest or dividends more frequently (quarterly, or monthly, for example). The annual rate may be the same, but it’s split into multiple smaller payments. This means you can start earning compound interest even sooner. And this in turn means you’ll earn a bit more compound interest than you would have with an account that only paid annually. So it’s worth checking interest or dividend payment frequency before you invest in an asset.

If your ISA provider boasts about the fantastic interest rate it pays on uninvested funds, bear in mind that it will typically have already incorporated the effects of compounding. If it talks about a “gross” rate or an “annual equivalent rate” (AER) then regardless of whether the interest is paid weekly, monthly or annually, that quoted figure already takes into account compounding over a year.

Is it worth reinvesting interest from a stocks and shares ISA?

That depends on what you’re trying to achieve. If you’re investing for long-term growth, then the effect of compound interest will mean your stocks and shares ISA will grow in value faster than it would otherwise.

However, many people choose income-generating investments because they need the money to live on. If you need to withdraw money regularly (investing for income), then you won’t be able to benefit from compound interest in the same way.

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Worked example: compound interest in action

The table below shows how much difference compound interest can potentially make to your stocks and shares ISA. In our example, our investor puts £1,000 into assets that pay 5% interest annually. Over 20 years, their initial investment would grow by £1,000 if they earned simple interest. Annual compounding would add an extra £653 onto this, and if their account compounded monthly they’d get £713 more than in the simple interest scenario.

Bottom line

If you can afford to do so, reinvesting any income you earn from your investments can lead to faster growth and help you meet your investment goals. The earlier you start investing (and reinvesting), the greater the benefits of compounding will be. Not all investments grow in this way, though; with many, the growth will come through capital gains (an increase in the value of the investment itself). Neither is inherently better or worse. They’re just different. If you need help choosing the right investments to meet your goals, consider speaking to a professional financial adviser.

Frequently asked questions

• What is the average return on a stocks and shares ISA?

  That’s a tricky question to answer, as the average annual return varies depending on market conditions. According to financial product data provider Moneyfacts, the average stocks and shares ISA fund returned 13.55% between March 2020 and March 2021. But between February 2021 and February 2022 the average return was just 6.92%. Meanwhile the turbulence caused by political upheaval and global economic uncertainty in late 2022 may knock returns even further. However, as we’ve said above, investing is for the long term, and history suggests that stock market performance is likely to recover in the future.

• Does interest on stocks and shares ISA compound daily or annually?

  It depends on the specific investment and how often interest is paid. Some pay interest annually, but others will do so more frequently (quarterly, monthly, or even daily).