Understanding compound interest and using it to your advantage can make a huge difference for your personal finances. And since Einstein said something like this about compound interest… we should all probably take notice.
Let’s find out why.
What is interest?
Let’s start with the definition of interest, and build from there:
Interest that you earn on savings is basically a thank-you from the bank for depositing your money with them.
Why do they do this? Because whenever you save money in an account, that bank or institution is able to lend more money out to others.
These loans (in the form of mortgages, personal loans etc.) will all have higher interest rates than you’re paid for your savings - so they’re able to earn a lot of money thanks to you.
What’s more, they’re not only allowed to lend out an amount of money equal to the amount you deposit - they’re allowed to lend out a multiple of this, meaning they can earn even more.
That’s why they’re happy to pass a bit of the money they’re earning onto savers.
What is simple interest vs compound interest?
When you put money into a savings account, you’ll earn interest on the money you deposit.
The interest rate (which is called the AER, or Annual Equivalent Rate) tells you how much your money will increase per year.
Simple interest
For example, if you deposit £1,000 into a savings account that has an AER of 3%, after one year that money (as long as you don’t withdraw any) will increase to £1,030.
This is simple interest - you deposit money, and earn interest on that amount.
Compound interest
But imagine you leave your £1,030 in that account for another year and the interest rate on your account stays at 3%.
You might think that, since in the first year the total amount increased by £30, after two years you’ll have £1,060.
But that’s not quite right.
You’ll actually end up with more - £1,030 x 1.03 (to represent the 3% interest rate) = £1,060.90.
It’s not a huge difference at this point - but this will grow into a big difference over time.
Why is it called compound interest?
You earn interest not just on the original amount of money that you deposited, but also on the interest you’ve already earned.
This means the effect of the increase is compounded and your money grows more quickly than it would if you only earned interest on your initial deposit (the £1,000 in the example above).
The true power of compounding
Now, this is where it gets interest(ing).
Once the amount in your savings account has grown to £1,060.90, interest is then earned on THAT amount, and so it goes on… and on… and on!
Here’s how it plays out over 1, 2, 10, 20 and 30 years:
£1000 + 3% interest a year =
£1,030 after 1 year
£1,060.90 after 2 years
£1,343.92 after 10 years
£1,806.11 after 20 years
£2,427.26 after 30 years
And that’s not factoring in any extra money you might also add to the account over time.
The effect of saving more money every year
If, as an example, you add £200 a year to your savings account, the final amount after 30 years would be £11,942.35 - from only depositing £7,000 in total! 🤯
Plus, the higher the interest rate on your savings account, the more quickly your money will compound and grow.
Here’s a great compound interest calculator to see how compounding can grow your money.
Compound interest: what to be aware of
Compound interest can’t work its magic if you stuff your money under the mattress like this guy did.
As long as you’re saving with an institution that’s covered under the Financial Services Compensation Scheme (FSCS) in the UK, your money is protected up to the value of £85,000 - so you don’t need to worry about your money going missing.
So it’s always better to have your money in a savings account than in cash.
Why? Because your money will only grow in real terms (what your money can buy you, rather than just the number in your bank account) if it’s earning more in interest than the rate of inflation i.e. what your money can buy will…
-
Increase if your money grows at a faster rate than inflation
-
Stay the same if it’s growing at the same rate as inflation
-
Decrease if your money grows at a rate that’s less than inflation
Inflation is the rate at which prices are rising in general. So if inflation is at 4% and you have £1000, you would need £1,040 in a year’s time to buy the same lot of stuff that would have cost £1000 this year.
Learn more about inflation by completing our pathway:
Compound interest and debt
While compound interest can be great when it’s working in your favour with savings - on the flip side, it can threaten your financial wellbeing when it comes to debt.
If you have any debt (including credit cards or overdrafts that charge you interest) and you don’t pay it off in full every month, you’ll be charged interest on the money borrowed - which, month after month, will compound, meaning you end up owing more and more money.
This can lead you into a debt spiral where the amount you owe becomes uncontrollable.
So it’s best to pay off any debt (excluding student debt) as soon as possible - especially important when interest rates are rising, as the amount you owe will grow more quickly when interest rates are rising.
Read this blog to understand why just paying the minimum repayment on a credit card isn’t enough.
Investing
Often, the interest rates on savings accounts are lower than inflation. This would mean that, even though it’s still better than having your money in cash, your money is losing value in real terms by being in a savings account.
One of the best ways, long term, to grow your money faster than inflation is through investing.
Check out our Investing 101 pathway to understand why it’s one of the best ways to achieve financial freedom.
Learn more about compound interest
To learn more about the power of compounding and how you can use compound interest to elevate your finances, check out our Savings pathway:
Avoid compound interest working against you and damaging your financial wellbeing by going through our Debt pathway:
