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.
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.
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:
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.
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.
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?
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.
"As you’ve probably gathered by now, compounding means that you earn more in the long run than you would if the investments in your stocks and shares ISA only paid simple interest (or if you withdrew your investment income rather than reinvesting it). And this helps your investments to grow.
You already know that investment works best when it’s for the long term. The same applies to compounding. The longer you keep your money invested, reinvesting any income you’re paid, the greater the exponential growth could potentially be. Subject, as always to the usual caveats about investment risk, and the potential for poor market performance."
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.
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.
| Simple interest | Compound interest paid annually | Compound interest paid monthly | |
|---|---|---|---|
| Initial investment | £1,000.00 | £1,000.00 | £1,000.00 |
| Year 1 | £1,050.00 | £1,050.00 | £1,051.16 |
| Year 2 | £1,100.00 | £1,102.50 | £1,104.94 |
| Year 3 | £1,150.00 | £1,157.63 | £1,161.47 |
| Year 4 | £1,200.00 | £1,215.51 | £1,220.90 |
| Year 5 | £1,250.00 | £1,276.28 | £1,283.36 |
| Year 6 | £1,300.00 | £1,340.10 | £1,349.02 |
| Year 7 | £1,350.00 | £1,407.10 | £1,418.04 |
| Year 8 | £1,400.00 | £1,477.46 | £1,490.59 |
| Year 9 | £1,450.00 | £1,551.33 | £1,566.85 |
| Year 10 | £1,500.00 | £1,628.89 | £1,647.01 |
| Year 11 | £1,550.00 | £1,710.34 | £1,731.27 |
| Year 12 | £1,600.00 | £1,795.86 | £1,819.85 |
| Year 13 | £1,650.00 | £1,885.65 | £1,912.96 |
| Year 14 | £1,700.00 | £1,979.93 | £2,010.83 |
| Year 15 | £1,750.00 | £2,078.93 | £2,113.70 |
| Year 16 | £1,800.00 | £2,182.87 | £2,221.85 |
| Year 17 | £1,850.00 | £2,292.02 | £2,335.52 |
| Year 18 | £1,900.00 | £2,406.62 | £2,455.01 |
| Year 19 | £1,950.00 | £2,526.95 | £2,580.61 |
| Year 20 | £2,000.00 | £2,653.30 | £2,712.64 |
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.
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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