Saturday, 14 October 2017 15:23

Understanding Compound Interest

Most people know interest rates are currently very low. That’s great for mortgage payers, but not so good if you have savings. but it does pay to know more about interest rates and what effect they can have on the amount you are saving. And to do that, it is worth learning about the effect of compound interest. Once you know how it works, you could end up saving more than you ever thought possible.

Compound interest is all about the concept of earning interest on your interest. If you keep money in a savings account, it should earn you interest. But if you don’t touch that money, you will end up getting more interest in the second and subsequent years than you did in year one – assuming all else remains equal.

So, how does it work?

Let’s assume you put £100 in a savings account. You get a rate of 5% interest. (That’s probably impossible to find now, but we’ll use it for the purposes of an easy example.)

One year goes by. You get your 5% interest annually, so it doesn’t take much brain power to work out that after one year, you get £5 in interest. This is added to your balance to give you £105.

So far, so good. You don’t touch that money, and you don’t put any more in, either. By the time the second year has been completed, you earn another 5% in interest. Except this time, you get 5% on £105, because the interest from the first year is still there. That means you get £5.25 this time. This is added onto the existing balance to take that up to £110.25.

After year three

Fast-forward another year, and you get £5.51 in interest. This boosts your balance to £115.76.

Let’s see how this continues up until year 10:

Year four – £121.55

Year five – £127.63

Year six – £134.01

Year seven – £140.71

Year eight – £147.75

Year nine – £155.14

Year 10 – £162.90

You’ll probably have noticed the amount added each year becomes larger. By year 10, the amount of interest earned has become £7.76, compared with £5 in year one. This happens because you are earning interest on interest, and remember, in our example, we haven’t allowed for adding in any further savings on top of the original £100. But in the space of 10 years, the original capital has grown considerably.

This can be done with any savings account and any sum of money. Of course, the more you can save the better, and the bigger the interest rate, the better. The task is to save whatever you can, and not to touch the capital or the interest. Sometimes, swapping your cash over to a different savings account will produce a better return, if you can find an account with a better rate of interest.

But keeping the compound interest formula in mind means you will understand how much bigger your savings can be over time – no matter how good or bad the interest rates might be.