How Does Compound Interest Work?
*This is a collaborative post on compound interest but all thoughts and words are my own
Life is expensive and I’m sure everyone is saving for something. It might be a house, a wedding, a new car, your retirement, the list goes on. And most of us are probably saving for multiple things at the same time.
There are a few ways you can earn more interest on your money, but compound interest is the biggest one. I’m sure most of us don’t like tying our savings up for long periods of the time but it’s the best thing you can do to help it grow. Leave it there, don’t touch it and watch it get bigger.
What is compound interest?
Compound interest is when you earn interest on both the money you have saved and any interest you’ve earned. As you earn interest each year the longer savings are put away the longer it has to earn interest.
For example you could save £500 a month for 20 years in a 2% interest account you’d have saved £120,000. But with compound interest you’d have £145,784.22 so over 25K extra. This is because at the end of year one you’d get 2% interest on the first £6,000 you’d saved. So you’d have £6,120. Then a year later you’d have the £6,3620.40 because you’d have the £6,120 from year one, an extra £6,000 you’d saved and then 2% interest on top of that. And this will carry on for the whole time that you’re saving.
If you saved £120,000 in one go and got your 2% interest you’d only have £122,400 compared to over £145,000 if you’d saved the same amount over 20 years.
How you can gain compound interest through investing
General savings accounts or ISA’s won’t generally get you much interest, especially at the moment. So the 2% example above is quite generous, but you can earn a lot more compound interest through investing. With investing you can gather both earnings and interest. There’s always a risk of losing money, but if you’re able to tie your money up for a longer period of time it’s deemed that there’s less risk. Generally investments tend to average around an 8% return. This alone is huge compared to the number above.
If you invested £6,000 a year for 20 years like the example above you’d be left with £274,571.79 (assuming an 8% interest/ growth rate). So an increase of over £54,000 compared to what you’d actually saved. This is a huge difference! But do it over even longer and you’ll see even bigger results. Save that over 30 years without interest and you’ll have £180,000, but get 8% investment interest over 30 years and you’ll have £679,699.27! It really is true the longer you put money aside the more compound interest increases your returns.
If you’re looking to start investing you can use trading app comparison to find out the differences between apps to choose the best one for you.
Do you understand how compound interest works?
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15 responses to “How Does Compound Interest Work?”
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Rhian Westbury
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This takes me back to my banking days of working in a building society, I used to be able to work out daily interest and compound interests. Please don’t ask me to do it now, but so easy to understand in your post
I bet you’d come home from a day at work with numbers swimming around your mind x
I didn’t know a lot about this, it is always good to have more info and this post was quite helpful.
My husband and I were discussing the same the other day in regard to the share market investment. And today, I am reading this post! Thanks for explaining everything in detail
What good timing! And a great discussion for you and your husband to be having x
How interesting to learn more about compound interest as I was just talking about this yesterday with a friend. You have explained it clearer
Compound interest occurs when interest gets added to the principal amount invested or borrowed, and then the interest rate applies to the new (larger) principal – which I had difficulty understanding it just few days ago.
Thanks for the detailed explanation.
That’s exactly how it works, I’m glad my explanation helped x
Thank you so much for this. I don’t know much about compound interest so this was definitely a must read since I want to get into investing and better money management.
Interest is so seldom positive! It really does just compound!
I never knew this! These are such cool facts and now I feel a tad bit smarter!
What an interesting article, I had no idea how compound interest worked at all.
I’m glad I could help explain it x
Thanks so much for sharing your knowledge with us – I’ve only opted for a low interest but very low risk ISA as I’m nervous about additional risks although will look into this more as I want my money to work better for me
Laura x
It is tough when you don’t want that much risk, but even with low risk investing compound interest still comes into play, you’ll just get a bit less interest x