How Compound Interest Works (With Examples)
Compound interest is one of the most powerful concepts in personal finance. It allows your money to grow faster over time by earning interest on both your original deposit and the interest it has already generated. Whether you are building an emergency fund, saving for retirement, or investing for long-term goals, understanding compound interest can help you make smarter financial decisions.
What Is Compound Interest?
Compound interest means you earn interest not only on your initial amount (the principal) but also on the interest you have already earned. This creates a snowball effect where your savings or investments grow at an increasing rate over time.
A simple way to think of it is: your money earns interest, that interest is added to your balance, and then the new total earns even more interest in the next period.
Simple Interest vs Compound Interest
| Feature | Simple Interest | Compound Interest |
|---|---|---|
| How it works | Interest calculated only on the initial deposit | Interest calculated on the deposit plus accumulated interest |
| Growth over time | Linear | Exponential |
| Example (after 5 years at 5%) | £1,000 becomes £1,250 | £1,000 becomes £1,276 |
Worked Example with Annual Compounding
Let’s say you deposit £1,000 in a savings account paying 5% interest per year, and you leave it untouched for five years. Here’s how the balance grows:
| Year | Starting Balance | Interest Earned (5%) | End Balance |
|---|---|---|---|
| 1 | £1,000.00 | £50.00 | £1,050.00 |
| 2 | £1,050.00 | £52.50 | £1,102.50 |
| 3 | £1,102.50 | £55.13 | £1,157.63 |
| 4 | £1,157.63 | £57.88 | £1,215.51 |
| 5 | £1,215.51 | £60.78 | £1,276.29 |
The difference between £1,250 with simple interest and £1,276 with compound interest may seem small at first, but over decades the gap becomes enormous.
Compound Interest with Monthly Contributions
Suppose you invest £100 per month in a Stocks and Shares ISA earning an average 5% annual return, compounded monthly. After 10 years:
- Total paid in: £12,000
- Estimated total value: ~£15,600
- Growth: ~£3,600 from interest alone
If you continued for 30 years, your £36,000 of contributions could grow to around £75,000, assuming the same growth rate and no withdrawals.
Why Starting Early Matters
Starting earlier often beats starting with larger amounts later. For example:
- £100 per month for 30 years → ~£75,000
- £200 per month for 10 years → ~£31,000
Even though the second person contributes the same total amount (£36,000), the longer time frame in the first example allows compounding to work much harder.
Where You Benefit from Compound Interest
- Stocks and Shares ISAs – long-term growth, tax-free
- Pensions – decades of compounding with tax benefits
- Cash ISAs and savings accounts – safer but lower returns
- Reinvested dividends – buying more shares increases future income
Common Mistakes That Reduce Compounding
- Withdrawing interest instead of reinvesting it
- Paying high account or fund fees that eat into returns
- Stopping contributions too early
- Chasing high returns without considering risk
Tips to Maximise Compound Growth
- Start as early as possible, even with small amounts
- Reinvest all interest and dividends
- Keep investment costs low
- Be consistent with contributions
- Avoid unnecessary withdrawals
Compound Interest Calculator
Use our free compound interest calculator to see how your savings could grow with different amounts, interest rates, and time frames.
Frequently Asked Questions
Is compound interest always better than simple interest?
Yes in most savings or investment situations, but if you are borrowing money, compound interest can work against you by increasing the total amount you owe.
How often is interest compounded?
This depends on the account. It can be daily, monthly, quarterly, or yearly. More frequent compounding usually leads to faster growth.
Does inflation affect compound interest?
Yes. Inflation reduces the real value of your returns, so your interest rate should ideally be higher than the inflation rate to maintain purchasing power.
Final Thoughts
Compound interest is a powerful ally for building wealth. The earlier you start and the longer you let it work, the more dramatic the results. Whether you use it for savings, pensions, or investments, patience and consistency are the key ingredients for success.