What Is Compound Interest & How Does It Work?

AD| Compound interest occurs when interest gets added to the principal amount invested or borrowed. It's essentially interest on interest, which can in some cases work to your advantage as your savings and/or investments grow over a period of time. Compound interest plays an important financial role in both your savings, investments and any debts you might have. Understanding how this works could help you to make more money over time—or it could mean you pay more in interest if you're not careful with your planning.

The difficult thing about compound interest is that it can be both a good and a bad thing, depending on how you utilize it. For example, it’s great when interest compounds on an investment, allowing your contribution to grow. However, when compound interest is added to say a loan or debt on a credit card, it's not great because that's extra money you’ll have to pay back.


What’s The Difference Between Simple & Compound Interest?
Simple interest is the interest you earn or accrue on the amount you invest or borrow. For example, say you invest £100 and earn 10% interest on your investment in a year. The interest earned would be £10. This £10 is simple interest.

Compound interest is the extra interest you earn in addition to the simple interest you've already earned. For example, with compound interest, the extra interest is added to your initial amount. So that £10 of interest would be added to your total, meaning you now have £110. Year-on-year, this amount would keep increasing as your compound interest would keep adding to your total.

So How Does It Work?
Say for example you put £1,000 into a savings account that had a 10% interest rate that compounds annually. At the end of the first year, you'll have £1,100. The £1,000 you initially put in to it, plus the £100 in interest. Then, at the end of the second year, you'll have £1,210. The £1,100 from the previous year, plus the additional £110 in added interest.

Compounding interest works slightly differently as instead of calculating interest based only on the original amount you put into savings, compounding interest calculates your annual interest based on your original amount, plus any previous interest you earned the previous year. So by the end of the 10th year, you'll have £2,594 (based on the 10% interest rate). You’ll have doubled your initial savings, without having to add any more of your own money. This is all thanks to compound interest.

How Do You Calculate Compound Interest?
To be able to calculate compound interest, there are a few things you need to work out first.
1. The amount you plan to invest that will be eligible for compound interest.
2. The interest rate on this amount.
3. How often compounding will occur.
4. How long your interest will compound.
Once you have the answers tool of the above, you will be able to calculate compound interest for your investment. Here is a reliable compound interest calculator you can use.

Use Your Knowledge of Compounding Interest Wisely
Once you understand how compounding works, you can make better, more strategic financial decisions. For example, you could look for a savings account that offers daily compound interest, instead of yearly. This means you can then transfer your savings into the account as frequently as possible. The more money you have in there, the more interest you will get from it, meaning you’ll get more of a return.

Hopefully this article will help you when it comes to working out if compound interest is for you.

Are you aware of compound interest?

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