Albert Einstein reportedly said, ‘Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.’ But what is it?
Compound interest allows your savings to grow and eventually snowballs. When you earn interest on your savings, that interest is then added into your account. But then, next time you earn interest, you earn it on your original savings PLUS the interest that was paid to you before. In other words, your interest is compounded.
Simply, the more you can save, the higher the interest rate you’re paid (as long as you leave it), the larger and larger your balance will become. All as a result of compound interest.
Example
You have £1,000 to deposit into a savings account that pays an interest rate of 5.00%.
At the end of the first year, you earn £50 (£1,000 x 5%) into your account as interest.
Now, your account balance is £1,050 at the start of the second year.
At the end of the second year, you earn a further £52.50 (£1,050 x 5%) into your account as interest. Not only did you get interest on your original £1,000 of savings, but also on the £10 of interest earnt.
At the start of year three, your balance is now £1,102.50. The compounding effect would continue each year. By the end of year ten, your savings account would have £1,628.89.
If the interest was paid away from this account, you would only earn interest on the £1,000 each year and would only earn £500 compared to your compounded £628.89.
