How Compound Interest Works: Making Your Money Grow in the UK
A simple guide to compound interest for UK savers. Learn how your money can grow over time and get practical tips to maximise your savings.
Have you ever wondered how some people seem to grow their savings so well? The secret might be something called Compound Interest. Let's break down what this is and why it matters to your money in the UK's current financial landscape.
What Is Compound Interest?
Compound interest is when you earn interest, not just on the money you save, but also on the interest you've already earned. ,Think of it as "interest on interest."
It's like a snowball rolling down a hill. ,As it rolls, it picks up more snow, gets bigger and then picks up even more snow because it's bigger. Your money works the same way with compound interest.
How Does It Work?
Let's use a simple example:
Imagine you put £100 in a savings account that pays 5% interest each year.
After 1 year: You earn £5 interest (5% of £100). Your total is now £105.
After 2 years: You earn £5.25 interest (5% of £105). Your total is now £110.25.
After 3 years: You earn £5.51 interest (5% of £110.25). Your total is now £115.76.
Notice how the interest you earn increases each year, even though the interest rate stays the same? That's because you're earning interest on a bigger amount each time.
Compound Interest vs Simple Interest
To understand why compound interest is special, let's compare it with simple interest:
Simple interest: You only earn interest on your original money (the principal).
Compound interest: You earn interest on both your original money AND the interest you've already earned.
Using our example of £100 at 5% interest:
With simple interest after 10 years: £100 + (£5 × 10) = £150
With compound interest after 10 years: £162.89
The difference might seem small at first, but it grows bigger over time.
The Power of Time
The real magic of compound interest happens when you give it lots of time. This is why people say to start saving early.
If you put £1,000 in a savings account with 5% interest:
After 10 years: about £1,629
After 20 years: about £2,653
After 30 years: about £4,322
That's more than four times your original money after 30 years, and you didn't have to add another penny!
How to Make Compound Interest Work for You in the UK
Start early: the sooner you start saving, the more time compound interest has to work its magic.
Save regularly: addina even small amounts to your savings boosts the compound effect. Setting up a monthly direct debit to your savings account can help.
Be patient: compound interest isn't about getting rich quickly; it's about building wealth steadily over time.
Choose wisely: look for competitive UK savings options like easy-access accounts, fixed-rate bonds, Cash ISAs, or Stocks and Shares ISAs with good interest rates or returns.
Max out your ISA allowance: remember that ISAs are tax-free, so the full interest amount compounds without HMRC taking a cut.
Consider premium bonds: while not technically offering compound interest, your chances of winning increase with more bonds.
Don't touch it: every time you take money out, you reduce the snowball effect.
Watch Out!
Compound interest can also work against you with debts like credit cards. If you have debt with high interest rates, the amount you owe can grow quickly if you only make minimum payments.
Wrapping Up
Compound interest might seem like a small thing, but it's one of the most powerful tools for building wealth over time. The earlier you start saving, the harder your money can work for you.
Remember: You don't need to be rich to start. Even small amounts can grow into something meaningful with time and the power of compound interest.
"Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it." — Often attributed to Albert Einstein
Frequently Asked Questions About Compound Interest
What's the difference between AER and APR?
AER (Annual Equivalent Rate) shows what the interest rate would be if interest was paid and compounded once a year. It's the rate to look at when comparing savings accounts.
APR (Annual Percentage Rate) is used for loans and credit cards. It includes the interest rate plus any fees, making it important when comparing borrowing costs.
How often is interest compounded in UK savings accounts?
Most UK banks compound interest daily, monthly or annually. The more frequently interest is compounded, the more your money will grow over time.
Do I pay tax on my compound interest in the UK?
If you're a basic rate taxpayer, you have a Personal Savings Allowance of £1,000 of interest per year tax-free. For higher rate taxpayers, this drops to £500. Additional rate taxpayers get no allowance. However, ISAs remain completely tax-free regardless of how much interest you earn.
Is compound interest better in a pension or an ISA?
Both benefit from compound interest, but in different ways:
Pensions get tax relief on contributions and can grow tax-free, but you can't access them until age 55 (rising to 57 in 2028).
ISAs offer tax-free growth and flexible access to your money, but don't receive the initial tax relief boost.
What's the best age to start saving with compound interest?
The best time to start is now! However, the earlier you begin, the more powerful compound interest becomes. Starting in your 20s versus your 40s can result in significantly more wealth by retirement age.
Useful Resources
HMRC Tax on Savings Interest - Official guidance on savings tax