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Understanding compound interest – and how it can help your savings grow
22 September 2025
Interest is possibly one of the simplest and most powerful ways to make your money work harder. But not all interest is created equal. While simple interest offers steady growth, compound interest can accelerate your savings potential by letting you earn interest on both your initial deposit and the interest you’ve already earned.
For anyone eager to build a stronger financial future without devoting much time, this article explains what compound interest is, how it’s calculated and why starting early can make a big difference.
Simple interest vs. compound interest
When you put money into an interest-earning account, the bank or building society pays you a percentage of your balance as interest. The amount you earn depends on:
- The interest rate – A higher rate means more earnings over time.
- The length of time you save – The longer your money stays in the account, the more interest it can earn.
- The type of interest – Whether it’s simple or compound interest.
Simple interest is calculated only on your original deposit (the ‘principal’). For example, if you keep £5,000 in a savings account at a simple interest rate of 5% AER (fixed) for one year, you’ll earn £250 in interest, giving you a total of £5,250.
Compound interest, on the other hand, is calculated on your principal and the interest you’ve already earned. This “interest on interest” effect means your savings can grow faster over time.
How compound interest works
Let’s say you maintain a principal balance of £5,000 in an account paying 5% AER (fixed), with interest accrued daily and paid monthly.
- After one year, your balance would grow to £5,255.81* – that’s £255.81 in interest.
- After two years, your balance would reach £5,524.71* – earning £268.90 in the second year alone. That’s because you’re earning interest on your original £5,000 plus the interest you earned the previous year.
Why start now?
The longer you leave your money in an account with compound interest, the more powerful the effect becomes.
If you left that same £5,000 untouched for 20 years at 5% AER (fixed), you’d earn £8,563.20 in interest – finishing with a balance of £13,563.20*.
And you wouldn’t have to add another penny along the way.
Key takeaway
Whether you’re saving for a rainy day, a big purchase, or your retirement, choosing an account with compound interest – and starting as soon as possible – can help your money grow more effectively.
*Based on a fixed interest rate of 5% AER. These projections assume you make no withdrawals or further deposits other than those mentioned, that the interest rate doesn’t change and that interest is paid monthly into the account. It’s for illustrative purposes only and doesn’t take into account individual circumstances.
AER stands for Annual Equivalent Rate and illustrates what the rate would be if interest was paid and compounded once each year.
| Savings interest rate (AER)(1) |
Savings Balance Before Paying Tax | |
| Basic rate taxpayer | Higher rate taxpayer |
|
|---|---|---|
| 1% | £100,000 | £50,000 |
| 2% | £50,000 | £25,000 |
| 3% | £33,333 | £16,667 |
| 4% | £25,000 | £12,500 |
| 5% | £20,000 | £10,000 |
The content in this article is for information only and is not advice. All content in this article was accurate on the date of publication shown above.
The content in this article is for information only and is not advice. All content in this article was accurate on the date of publication shown above.
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