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What is Compound Interest?

Compound interest is one of the most powerful financial concepts you can use to grow your money over time. Whether you're saving for the future or paying off debt, understanding how compound interest works can help you make smarter financial decisions.

In this guide, we'll explain:

  • What compound interest is
  • How it works (with simple examples)
  • The difference between compound and simple interest
  • How to make compound interest work for you
  • Tips to maximise your savings

Let's dive in!

1. What is Compound Interest?

Compound interest is interest earned on both your original money (the principal) and the interest you've already accumulated.

Unlike simple interest (which only grows based on the original amount), compound interest grows faster because your money earns interest on top of interest.

Example of Compound Interest

Imagine you put £1,000 in a savings account with a 5% annual interest rate, compounded yearly.

  • Year 1: £1,000 + 5% = £1,050
  • Year 2: £1,050 + 5% = £1,102.50
  • Year 3: £1,102.50 + 5% = £1,157.63

After 3 years, you've earned £157.63 in interest—more than you would with simple interest (£150).

The longer you leave your money, the faster it grows!

2. How Does Compound Interest Work?

Compound interest depends on three key factors:

  1. Principal (P) – The initial amount of money.
  2. Interest Rate (r) – The percentage earned or charged each year.
  3. Time (t) – How long your money is invested.

The formula for compound interest is:

A = P × (1 + r/n)n×t

Where:

  • A = Final amount
  • P = Principal
  • r = Annual interest rate (decimal)
  • n = Number of times interest is compounded per year
  • t = Time in years

Different Compounding Frequencies

The more frequently interest is compounded, the more you earn:

Frequency Times Compounded (n)
Annually 1
Quarterly 4
Monthly 12
Daily 365

Example:

£1,000 at 5% for 5 years:

  • Annually: £1,276.28
  • Monthly: £1,283.36
  • Daily: £1,284.00

Even small differences add up over time!

3. Compound Interest vs. Simple Interest

Feature Compound Interest Simple Interest
Growth Faster (exponential) Slower (linear)
Calculation Interest on principal + past interest Only on principal
Best for Long-term savings Short-term loans

Example:

£10,000 at 5% for 10 years

  • Simple Interest: £15,000 (£500/year)
  • Compound Interest: £16,288.95

That's £1,288.95 extra just from compounding!

4. How to Make Compound Interest Work for You

💡 Saving & Investing Tips

  • Start Early – The sooner you invest, the more time your money has to grow.
  • Increase Frequency – Choose accounts with monthly or daily compounding.
  • Reinvest Dividends – If investing in stocks, reinvest earnings for faster growth.
  • Avoid High-Interest Debt – Credit cards compound interest against you!

Best Accounts for Compound Growth

5. The Power of Starting Early

Let's compare two people:

  • Alex starts saving £200/month at age 25 (7% return).
  • Sam starts saving £200/month at age 35 (same return).

By age 65:

  • Alex: £525,000
  • Sam: £245,000

Alex invested £24,000 more but ended up with £280,000 extra just by starting earlier!

6. Compound Interest & Debt (The Dark Side)

While compound interest helps savings, it hurts when you owe money:

  • 💳 Credit Cards (20%+ APR)
  • 📱 Payday Loans (1,000%+ APR)

Example:

  • £1,000 credit card debt at 20% APR (minimum payments):
  • Could take 20+ years to pay off!
  • Total repaid: £3,000+

Tip: Pay off high-interest debt first (check MoneySavingExpert's Debt Calculator).

7. FAQs About Compound Interest

How often should interest compound?

The more frequent, the better (daily > monthly > yearly).

Can I calculate compound interest easily?

Yes! Use online calculators like:

Does inflation affect compound interest?

Yes! If inflation is 3% and your return is 2%, your real growth is -1%.

8. Final Tips to Maximise Compound Interest

  • 🚀 Start now – Even small amounts grow over time.
  • 📈 Invest wisely – Stocks & funds usually beat savings accounts long-term.
  • 💳 Avoid bad debt – High-interest loans wipe out gains.
  • 🔄 Automate savings – Set up direct debits to invest consistently.

Conclusion: Compound Interest is Your Best Friend!

Whether saving for retirement, a house, or an emergency fund, compound interest helps your money grow faster. The key is to start early, stay consistent, and avoid high-interest debt.

💡 Action Step: Open a high-interest savings account or invest in an ISA today!

Useful Resources:

Now go make your money work harder for you! 🚀💰

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