What is Compound Interest?

Written by Karen Bryan

compound interestCompound interest is when interest is calculated on top of interest which has been earned in the past, as well as on the original balance. Compound interest can work against you if you are in debt, as the total amount that you owe can keep increasing (depending on the level of your loan repayments), but work in your favour if you have a savings account.

However, I’ll illustrate it as a positive thing and give a worked example below of getting compound interest on your savings.

I put £1000 into a savings account which pays 5% interest. At the end of year 1 my balance is £1050, made up of the 5% interest on £1000 which equals £50 plus the £1000 initial deposit.

If I leave that balance in the savings account for a second year, at the end of year 2 my balance will be £1102.50, made up of the 5% interest on £1050 which equals £52.50 plus the end of year 1 balance of £1050.

If I leave that balance in the savings account for a third year, at the end of year 3 my balance will be £1157.63, made up of the 5% interest which equals £55.12 plus the end of year 2 balance of £1102.50.

I’ve observed the cumulative effect of compound interest when saving up in my tax free Cash ISA savings accounts, where I try to pay in the Cash ISA maximum every year and each year’s interest is added in the account.

You can use this compound interest online calculator to work out the interest on savings or loans.