However, compound interest can have a huge impact on the amount you can save and if the great Albert Einstein did describe it as ‘the eighth wonder of the world’ as some have stated, then it’s certainly worth taking time to understand it.
When you earn interest on your savings, the interest is either paid into a different account, for instance if you are looking to use the interest you earn as an income, or stays in the same account.
If you leave the interest you earn in your savings account, rather than moving it, then the next time you earn interest you not only earn it on your original savings amount, but also on the interest you have accrued. In this way, your interest is compounded.
Compound interest can have a significant impact in savings. In his latest TEDx talk, co-founder of financial education charity RedStart, Rob Gardner, talks about the importance of compound interest and teaching people from a young age about making the most of their money. It’s an interesting listen. In a recent article he claims that by saving £5.50 a day for your child until they are 10 and investing it wisely, that compound interest could help grow this pot to one million pounds by the time they are 65.
While it may be hard to comprehend how just a few pounds in savings a day could result in such a large amount, let’s look at a simple example that may help to explain how it all works. Basically, the higher the number of compounding periods, the greater the amount of compound interest.
| Year | Opening balance | Interest at 2% | Closing balance |
| 1 | £10,000 | £200 | £10,200 |
| 2 | £10,200 | £204 | £10,404 |
| 3 | £10,404 | £208.08 | £10,612.08 |
| 4 | £10,612.08 | £212.24 | £10,824.32 |
| 5 | £10,824.32 | £216.49 | £11,040.81 |
So in this example for a savings account paying 2% where interest is compounded annually, the opening balance of £10,000 has grown to £11.040.81 over five years. If this saver had made further payments into their savings account over this period or left their money to accrue compound interest for longer, obviously the closing balance would be even greater.
Further information on compound interest is available from a number of sources including the Money Advice Service.
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Stuart Hulme
Director of Savings and Marketing