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What is compound interest?

Banks use all sorts of interest rates to lure in customers, including generous introductory interest rates. So, what is compound interest? Find out more right here.

What is compound interest?

Dating back to 17th century Italy, compound interest is essentially double-layered interest, i.e., it's interest on pre-existing interest. Also known as compounding interest, this 'interest on interest' allows faster growth than would be possible with simple interest.

What is the difference between simple and compound interest?

Simple interest is interest gained on the money you deposit into your account. This is also known as the principle.

Compound interest is interest earned not just on your principle but on the interest your principle has earned. Banks will offer savings accounts with interest rates that are based on compound interest, which is why it is encouraged to create a standing order to move money into your savings account each month so that you can earn more interest on the existing interest on your principle.

How does compound interest work on savings accounts?

As we said, compound interest builds on the interest you already have. When it comes to selecting a bank account, it's crucial to understand how this impacts your savings and their growth. Most banks will offer a simple interest rate of around 1%, which means if you have $1,000 in your account, after a year, you would have $1,010.

Compound interest would build on this amount. If, for example, your interest is compounded daily through the year, you will get 1/365th of that 1% interest rate every single day. This means that at the end of the year, you have $1,010.05. Many savings accounts, like ISAs, are designed to accommodate years of savings. So, after a decade, you'll have around $1,105 – that's essentially $100 in "free money." Plus, if you are actively moving more money into the account, your simple interest will also increase.

How to calculate compound interest

Daily compounding interest is best for boosting your savings, but in reality, most banks will opt for monthly or yearly compounding. You can work out how much your compounded interest would be with the compound interest formula.

A = p(1 + r/n)nt

Where:

  • A = Final amount

  • P = Principle balance

  • R = Interest rate as a decimal figure

  • N = Number of times interest will be applied per period (usually a year)

  • T = Number of periods elapsed

So, let's assume you have deposited $5,000 at an annual interest rate of 5% due to be compounded monthly. After 10 years, you can use the compound interest formula to see how much interest your initial deposit has earned:

$5,000(1+0.05/12)(12*10) = $8,235.05

If you don't feel comfortable doing the calculation by hand, you can use compound interest calculators online to help you work it out. 

Are compound interest rates guaranteed?

No interest rate is guaranteed. A global crisis, internal bank issues, or merely a change of rates by your bank can see your interest rate drop at any time.

What do APR and APY mean for compound interest?

Banks will usually describe their compound interest rate as APY (annual percentage yield), reflecting their compounding interest. On the other hand, APR, annual percentage rate, does not reflect how many times interest has been compounded. Consequently, it would be best if you didn't base your decision on a new savings account on APR alone.

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