Compound interest on your savings could help earn you extra, but on a loan it can sink you further into debt. Find out why…
Albert Einstein summarised compound interest thus: “He who understands it, earns it; he who doesn’t, pays it.”
An understanding of it can help get across the importance of paying down debt as quickly as possible, and of starting saving at the earliest possible opportunity
Compound interest simply means you earn, or pay, interest on the interest accrued.
While compound interest can be very favourable for savers, it’s bad news for borrowers, so it’s important to know how it stacks up.
On 12 February, 2015, Gocompare.com checked 300 instant access savings accounts listed by independent financial researcher Defaqto and found that 83 paid interest monthly, 18 quarterly and 193 annually.
To make it easier to calculate how much interest you’ll earn in a year, banks state interest as the annual equivalent rate (AER), which takes the daily compounding interest into account.
As mentioned above, compound interest is also paid on the interest earned - so if you have £1,000 in a savings account earning 5% AER where the interest is paid to you each year, you’ll have £1,050 at the end of the year.
For the next year, you’ll earn 5% of £1,050 - so at the end of year two your savings will be worth £1,102.50.
You can sometimes opt to have your savings interest ‘paid away’, which means it’s paid into a different account.
This means you’ll benefit less from compound interest, as you won’t earn interest on the interest each year.
So, for the above example, if the interest was paid away to your current account when it became due at the end of the first year, you'd have an extra £50 in your current account and £1,000 in your savings account.
At the end of the second year, you would once again have £50 paid over and would still have £1,000 in your savings - so you would have lost out on £2.50 of interest.
It might not seem like much, but if you kept adding all the interest to the capital for 30 years the compounding effect would help you earn £3,467.74 in interest, which added to your initial investment would leave you with £4,467.74.
If the interest was paid away every year for 30 years you'd receive a total of £1,500 which, added to your initial investment, would leave you with just £2,500.
Of the 300 instant access accounts checked on Defaqto, just 16 would only pay the interest away rather than adding it to the savings account, although a further 194 gave the option of doing this.
He who understands it, earns it; he who doesn’t, pays it
Albert Einstein on compound interest
Remember, some current accounts may offer a high interest rate, perhaps a better one than dedicated savings accounts.
However, most of them have terms and conditions attached, such as an upper balance limit for interest - for instance they may pay 5% AER on balances up to £2,000 and 0% AER on balances above this.
This means that you won’t benefit from compound interest if you keep the maximum balance in the account, as the interest won’t then earn more interest.
The way around this would be to transfer the interest away regularly to another account, whether current or savings, that does pay interest.
Although investments in shares - perhaps through a Stocks and Shares Isa - doesn’t pay interest, if you invest wisely the effect of compounding can be very beneficial indeed.
This is because as well as the possibility that the shares you hold could increase in value - allowing you to sell them for a profit - they may also pay dividends, and this dividend capital can compound like interest.
If you pay such dividends back into the holdings company they can be used to buy more stock, meaning that dividends could be paid on these dividends at the next pay out, as well as on your original investment.
Of course, there's no guarantee of getting any returns at all on stocks and shares (under-performing investments may not pay out any dividends) and your original capital investment can be at risk (the value of the shares themselves may drop to nothing).
Also, if you choose to reinvest dividends into more stock the holdings company is likely to charge you a handling fee, which can further eat into your returns.
Read more about the pros and cons in our beginners' guide to investing.
For debt - whether that’s credit cards, loans or a mortgage - compound interest means interest is added to the interest already accrued each day, between your monthly payments.
When you take out a loan, compound interest will apply, so the interest builds daily between your monthly payments.
At the start of the loan it’s calculated over the whole term so that you pay off an equal instalment each month to clear the loan by the end of the term.
This can have implications if you choose to repay early - you might be surprised to find there’s a larger chunk of the loan still to repay than you thought, plus if there’s an early repayment charge based on one or two month’s interest, this could also be higher than you expect early on in the loan.
It’s the same with a mortgage - compound interest builds daily on a mortgage, but because the sums of money involved are so large the effect can be far greater, building up a sizeable chunk of interest between monthly payments.
Because of this, and the length of time most mortgages are spread over, you may be surprised to find that a very large part of your monthly payment consists of interest, particularly in the early years.
Compound interest on a credit card balance can accumulate especially quickly, due to the flexibility of choosing how much you pay off each month.
Since new rules came into effect in January 2011, the minimum balance you pay on your card will always clear the interest and reduce your balance by at least 1% each month, but paying the minimum could still mean it’ll take a long time to clear your card.
For instance, if you only pay off the minimum 3% balance on a 20% APR card with £3,000 on it, it’d actually take 19 years and nine months to repay - costing you £2,831 in interest in the process.