What does compound interest mean?

Albert Einstein reportedly once described compound interest as “the eighth wonder of the world”. But what exactly is it?

We all know that we earn interest on our savings. But what happens to the interest once we've earned it? It’s either moved (or paid) into a different savings or current account, or it stays in the same account and is added to your savings.

You might have your interest ‘paid away’ if you were looking to use the interest you earn on your savings as an income, for instance to supplement your pension in retirement. However, because your savings pot never gets a chance to grow, the amount you can buy with it will become less over time, due to the effects of inflation.

With compound interest, your savings have the chance to grow and snowball. When you earn interest on your savings, the interest you earn is added to your savings pot. Then the next time you earn interest, you not only earn it on your original savings amount, but also on the interest you have previously accrued – in other words, your interest is compounded.

Of course, the more you save and the longer you can leave it, the larger and larger your nest egg will become. And that is – in part – due to the effects of compound interest.

Vera has £1,000 to save. She decides on an account paying an interest rate of 2.00% annually.

At the end of year one she receives £20 in interest (as £1,000 x 2% = £20).

This £20 is added to her original £1,000 savings, making a new total of £1,020.

At the end of year two she’s earned £20.40 (as £1,020 x 2% = £20.40) because she’s not only been paid interest on her original £1,000, but also on the £20 interest she earned in year one.

The £20.40 is then added to her £1,020 to make a new total of £1,040.40.

The cycle then repeats again and again, so that by the end of year 10, her savings have grown to £1,218.98.

If she had this interest paid away from her savings account she would only earn £20 each year in interest, as she’d only ever be earning interest on £1,000. So, whereas with the interest compounded she would earn £218.98 over a 10-year period, with the interest paid away she would only earn £200.00.