What is interest?
Interest is money you earn on your savings when you put them in an interest-earning account. How much you earn depends on the interest rate offered by the bank or building society you choose to save with, and the length of time you leave your money in that account.
The interest rate you're on affects how much you earn on your savings. The higher the interest rate, the more money you'll earn and accumulate over time, so it has a significant impact on your savings.
However, it’s important to remember that interest rates can rise and fall because, in the UK, they are influenced in part by the fluctiations in the Bank of England base rate.
What does simple interest mean?
Simple interest is an easy concept to get your head around. If you place £500 into a savings account for a year at a simple interest rate of 5% AER (fixed), by the end of the year, you’ll receive £25 in interest, bringing your balance to £525.
In other words, simple interest is based on the principal amount of your deposit.
What does compound interest mean?
When we’re talking compound interest, things get, well, interesting.
Essentially, compound interest is based on the original amount you deposit, plus the accumulated interest of previous periods. You get interest on interest, and it helps your savings grow faster.
How to calculate compound interest
Let’s say you saved £5,000 in an account with an interest rate of 5% AER (fixed), with interest being paid into your account each month. At the end of the first year, you’d have £5,255.81* after earning £255.81 in interest.
At the end of the second year, you’d have £5,524.71*– that’s £268.90 in interest this year – because you would have earned interest on both your original savings and the interest you earned monthly from last year.