Albert Einstein reportedly once described compound interest as "the most powerful force in the universe".
But what exactly is compound interest?
We all know that we earn interest on our savings. But what happens to the interest once we've earned it?
It's either moved (or paid) into a different savings or current account, or it stays in the same account and is added on to your savings.
You might have your interest "paid away" if you were looking to use the interest you earn on your savings as an income, for instance to supplement your pension in retirement. However, because your savings pot never gets a chance to grow, the amount you can buy with it will become less over time, due to the effects of inflation.
With compound interest, your savings have the chance to grow and snowball. When you earn interest on your savings, the interest you earn is added to your savings pot. Then the next time you earn interest, you not only earn it on your original savings amount, but also on the interest you have previously accrued – in other words, your interest is compounded.
Let's look at an example.
You've got £1,000 to save. You decide on an account paying 2.00% interest after tax.
At the end of year one you receive £20 in interest (as £1,000 x 2% = £20).
This £20 is added to your original £1,000 savings, making a new total of £1,020.
At the end of year two you've earned £20.40 (as £1,020 x 2% = £20.40) – you've not only been paid interest on your original £1,000, but also on the £20 interest you earned in year one.
The £20.40 is then added to your £1,020 to make a new total of £1,040.40.
The cycle then repeats again and again, so that by the end of year 10, your savings have grown to £1,218.98.
If you had this interest paid away from your savings account you would only earn £20 each year in interest, as you'd only ever be earning interest on £1,000. So, whereas with the interest compounded you would earn £218.98 over a 10-year period, with the interest paid away you would only earn £200.00.
Now you might be thinking "£19 over 10 years isn't that much". However, the more you save and the longer you can leave it, the larger and larger your nest egg will become. And that is – in part – due to the effects of compound interest.
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Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.
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