What is compound interest?

Albert Einstein once described compound interest as the 'eighth wonder of the world'. Fortunately, you don’t have to be a genius like him to understand it. Put simply, it’s interest that earns interest. Almost as good as the Pyramids of Giza.

Key takeaways:

Compound interest is a powerful financial concept that allows your savings to grow exponentially over time.
The key difference between simple interest and compound interest is that simple interest is calculated only on the initial principal amount, while compound interest is calculated on the principal amount plus any accumulated interest.
The frequency of compounding can have a significant impact on the growth of your savings. The more frequently interest is compounded, the faster your savings will grow.
The power of compound interest can be demonstrated through the rule of 72, which estimates how long it will take for your investment to double based on the interest rate and compounding frequency.

Where have you heard about compound interest?

Savings accounts and cash ISAs are well-known examples of money that earns compound interest. The earlier you start investing in such products, the more time you’ll have for compound interest to take effect and make your savings grow.

What you need to know about compound interest

Compound interest gives you better returns than simple interest, which is calculated only on the principal sum invested.

For example, if you invest £1,000 for a period of 3 years with a 4% annual interest rate, the simple interest for each year will be £40. But, with compound interest, the interest for year 2 will be £41.60 because you would also earn 4% on the £40 interest you earned in year 1. In Year 3, instead of £40 you'd get £43.26

Although it doesn’t seem that much after only 3 years, if you save your money for a longer period, and keep adding to the pot, you can really see your savings snowball.

Calculating compound interest

To calculate compound interest, you need to know the principal amount, the interest rate, and the compounding frequency. Let's say you invest $1,000 in an account that earns 5% interest compounded annually. After one year, your investment will have grown to $1,050 ($1,000 x 1.05). If you continue to leave the money in the account and earn interest each year, your investment will continue to compound, and your earnings will start to accumulate. After two years, your investment will have grown to $1,102.50 ($1,050 x 1.05). After five years, your investment will have grown to $1,276.28 ($1,000 x 1.05^5). The longer you leave your investment in the account, the more it will grow thanks to the power of compound interest.