What Is Compound Interest and How Does It Work?
A simple explanation of compound interest - how it works, how it differs from simple interest, and how it applies to savings.
Compound interest is interest earned on both your original deposit and on the interest that has already been added. Over time, this creates a snowball effect - your money grows faster the longer it’s left to compound.
Compound vs Fixed Interest
With fixed interest, you earn a set amount of interest on your original deposit - the same amount each year. With compound interest, each time interest is added to your balance, the next interest payment is calculated on the new, higher amount.
Example - £1,000 at 5% per year:
| Year | Fixed interest balance | Compound interest balance | Difference |
|---|---|---|---|
| 1 | £1,050 | £1,050 | £0 |
| 3 | £1,150 | £1,158 | £8 |
| 5 | £1,250 | £1,276 | £26 |
| 10 | £1,500 | £1,629 | £129 |
| 20 | £2,000 | £2,653 | £653 |
| 30 | £2,500 | £4,322 | £1,822 |
With fixed interest, your balance grows by the same £50 every year. With compound interest, each year’s interest is slightly larger than the last - and after 30 years, that adds up to £1,822 more on the same £1,000.
How Compounding Frequency Matters
Interest can be compounded at different intervals - annually, monthly, or even daily. The more frequently it compounds, the more interest is generated, because each addition creates a slightly higher base for the next calculation.
Example - £10,000 at 5% for 1 year:
| Compounding frequency | Interest earned | End balance |
|---|---|---|
| Annually (once per year) | £500.00 | £10,500.00 |
| Monthly (12 times per year) | £511.62 | £10,511.62 |
| Daily (365 times per year) | £512.67 | £10,512.67 |
When comparing savings accounts, look for the AER (Annual Equivalent Rate) - this standardises the interest rate to account for compounding frequency, making it easier to compare products on a like-for-like basis.
NS&I Premium Bonds - a hybrid example
NS&I Premium Bonds are an interesting hybrid when it comes to compounding. Instead of paying interest, your bonds are entered into a monthly prize draw - and you can reinvest any prizes by buying more bonds, which increases your chances in future draws. In that sense, reinvesting prizes works similarly to compounding.
However, there’s a £50,000 maximum holding. Once you reach that ceiling, prizes are paid out as cash - there’s no way to reinvest further. At that point, your holding is effectively fixed and compounding stops.
For more on Premium Bonds and other tax-free options, see our article on tax-free ways to grow your money.
How Lunar Helps
Lunar tracks your savings and investment balances over time, so you can see how your money is growing across accounts and providers - all in one place. Lunar also includes forecasting tools that project how your savings could grow over time based on your current balances and interest rates.
Sources
Join the waitlist to track your savings with Lunar.
This article is for informational purposes only and does not constitute financial advice. If you're unsure about your finances, consider speaking to a qualified financial adviser.