Money will not start to work for you on its own, but one of the ways to achieve this is through something called compound interest. It is one of the easiest methods to grow your savings over time.
Investors’ guides to compound interest can get pretty complicated, but you don't need to be a money expert to get the hang of it. In this article, we will explain compound interest in simple terms, so you can understand exactly what it is and how you can take advantage of it.
The term "compound interest" describes the mechanism where you are earning interest not only on your original cash, but also on the interest you have already earned from it. It can almost look like money growing on top of money.
Let’s use the example of compound interest in a savings account. Here, the bank will pay you interest on your balance, and that interest is paid straight into your account, increasing your total. The next time you earn interest in that account, it is calculated based on that higher balance, making each new payment you receive greater than the one before. This assumes you make no withdrawals and the interest rate your bank pays you remains the same.
This cycle keeps on going and, over a long stretch of time, your savings will grow faster because each round of interest adds to the total pot. The longer you leave your money in the account, the more interest you will earn overall.
Tip: Having multiple bank accounts can help you make the most out of compound interest and still benefit from an easy way to save for different purposes (for instance, a pension versus a shorter-term savings goal), as long as you find the accounts with the best interest rates.
Compound interest is not the same as simple interest, so make sure you don't get the two confused.
Simple interest is when you only receive interest payments on the original amount that you transferred into your savings account. As a basic example, let's say you transferred £1,000 into a savings account that pays 5% simple interest each year. In this case, you will get £50 every single year and that interest never changes.
Compound interest works differently. The amount of interest paid into your account increases each year because the previous interest gets added to your balance:
This snowball effect can have a much bigger impact on the value of your savings in the long run.
A simple way to start earning compound interest is by opening a savings account or a cash ISA.
Certain types of investments also offer compound interest. If you don't feel confident enough to invest, but want to take your efforts further, you could consider working with a wealth manager (despite the name, you don't need to be wealthy to access their services!).
When you are comparing your options, have a look at the annual interest rates offered for different accounts and see how often interest payments are made. It is also worth using an online tool for calculating compound interest, so you can experiment with different savings amounts and interest rates and see exactly how the value of your savings could grow over time.
Let's close off this guide with our four top tips for making compound interest work for you:
Compound interest feels like a complicated concept, but it is much simpler at its core. The earlier you start saving and the longer you leave your money to grow, the more you will earn. It is a great way to make your money stretch further without extra effort on your part.
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