How does compound interest work on savings?

Full answer

Compound interest is often described as one of the most powerful forces in personal finance, since it means your money genuinely works harder for you the longer it remains invested or saved. **Simple interest vs compound interest** With simple interest, you earn a fixed amount of interest on your original capital each period, with no growth on the interest itself. With compound interest, previously earned interest is added to your balance and itself starts earning further interest -- over time, this creates an accelerating growth curve rather than a straight line. **The compounding formula** The basic compound interest formula is: Final amount = Principal × (1 + rate)^number of periods. The more frequently interest compounds within a year (daily vs monthly vs annually), the slightly higher your effective annual return, since interest is being added to the balance (and starting to earn its own interest) more often. **Worked example -- annual compounding** £10,000 saved at 4% annual interest, compounded yearly: Year 1: £10,400. Year 2: £10,400 × 1.04 = £10,816. Year 3: £10,816 × 1.04 = £11,248.64. After 10 years: roughly £14,802 -- notice the interest earned each year grows, since it is calculated on an ever-larger balance. **Why time matters more than the interest rate for long-term growth** The compounding effect becomes dramatically more powerful the longer money is left to grow -- £10,000 at 5% grows to roughly £16,289 after 10 years, but to roughly £26,533 after 20 years and £43,219 after 30 years, illustrating how the growth accelerates over longer time horizons rather than simply doubling the growth for double the time. **Compounding works against you with debt too** The same mathematical principle that helps savings grow also makes compounding debt (such as credit card balances or Lifetime ISA early withdrawal effects) grow faster the longer it is left unpaid -- understanding compound interest helps explain both why starting to save early is so valuable, and why clearing high-interest debt quickly matters. **AER (Annual Equivalent Rate) helps you compare** When comparing savings accounts with different compounding frequencies (some pay monthly, others annually), the AER figure standardises the comparison, showing what the effective annual return would be if interest compounded once a year -- always compare AER figures rather than headline nominal rates when choosing between savings products. **Practical tip** Use the Compound Interest calculator to model how your specific savings amount, interest rate, and time horizon combine, and consider making regular additional contributions alongside your initial lump sum, since regular contributions compounding alongside your original capital can significantly accelerate total growth compared with a single lump sum left untouched.

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