How Compound Interest Works and Why It Matters for Your Savings

Compound interest means earning interest on your interest. Each time your bank adds interest to your balance, the next payment is worked out on that bigger total. Over a year or two the effect is small. Over thirty years it does most of the work.

Simple interest and compound interest

With simple interest, you earn a return only on the money you first put in. Save £1,000 at 5% simple interest and you get £50 a year, every year.

With compound interest, the interest stays in the account and earns interest itself. The same £1,000 at 5% earns £50 in the first year, taking you to £1,050. In year two you earn 5% of £1,050, which is £52.50. The extra £2.50 looks trivial, but it keeps growing.

On a savings account, the figure to compare is the AER (annual equivalent rate). It shows what you would earn over a year once compounding is included, so an account paying interest monthly and one paying it annually can be compared fairly.

What time does to £1,000

Leave that £1,000 at 5% a year, add nothing, and it grows like this:

After 10 years: £1,629
After 20 years: £2,653
After 30 years: £4,322
After 40 years: £7,040

The balance grows by £629 in the first decade and by £2,718 in the last. That final decade adds more than the first twenty years put together, because each year's 5% is being worked out on a much larger sum.

A quick way to estimate this is the rule of 72: divide 72 by the interest rate to get roughly how many years it takes to double your money. At 5% that is about 14 years. At 2% it is 36.

Why starting early matters

Take two people, both investing £200 a month with growth of 7% a year (compounded monthly, after charges):

Alex invests from 25 to 35, then stops and leaves the money alone. Total paid in: £24,000.
Jordan starts at 35 and invests until 65. Total paid in: £72,000.

At 65, Alex has about £283,000 and Jordan about £245,000. Alex paid in a third as much and still ends up ahead, because Alex's money had an extra ten years to grow.

Seven per cent is an assumption. Shares have done better than that in some decades and much worse in others. At lower rates the gap shrinks, but the earlier money still has more years to compound.

The same maths works against you on debt

Debt compounds in the same way. Unpaid interest on a credit card gets added to the balance, and next month you pay interest on it.

Say you owe £5,000 on a card charging 20% APR and you pay only the minimum each month, here taken as 1% of the balance plus that month's interest, never less than £25. It would take about 18 and a half years to clear, and you would pay back around £11,700 in total. Paying a fixed £150 a month instead clears it in about four years for roughly £7,050.

Paying off a card at 20% gives you a guaranteed 20% return, which no savings account comes close to. For most people, clearing expensive debt comes before extra saving or investing, though it still makes sense to keep a small cash buffer for emergencies.

Getting compounding to work for you

Our [savings calculator](/savings-calculator) and [investment calculator](/investment-calculator) let you try different numbers. Four inputs drive the result:

Starting balance: a lump sum invested now gets the longest time to grow.
Monthly contributions: regular payments add up, and each one starts compounding as soon as it goes in.
Rate of return: shares tend to grow faster than cash over long periods but can fall sharply along the way.
Time: the input with the biggest effect, and the one you cannot get back later.

Tax can slow compounding down. Basic-rate taxpayers can earn £1,000 of interest a year tax-free under the Personal Savings Allowance (£500 for higher-rate, nothing for additional-rate), and HMRC taxes anything above that. Inside an ISA, where you can put in up to £20,000 a year, all interest and growth is tax-free.