How does compound interest work?

Compound interest could help you grow your savings. Learn more about how it works in our guide.

Compound interest works by building on the interest you’ve already made.

If interest was paid annually at a fixed rate you're able to work out easily how much interest you'll earn. For example, if the rate was 5% AER / gross and you had £1,000 in a fixed rate savings account, you’d earn £50 in interest in the first year – ending up with £1,050.

The second year is when compound interest starts to kick in. If the interest rate stayed at 5% AER / gross, you’d earn 5% on £1,050. So, you’d make £52.50 in interest this time.

The amount you earn in interest will continue to increase over the years, as the interest is added to the previous years.

You don’t need to rely on just compound interest to help build your savings. Regularly adding to your savings account can help keep your money growing.

If you have a savings account with a fixed interest rate paid annually, you can use an online compound interest calculator to work out how much interest you could potentially make over a number of years.

Another way you can see the effects of compound interest is by looking at the AER.

AER shows what you can earn in interest over a year as a percentage. For example, if you had £1,000 in a savings account which paid interest yearly at 3% AER:

Year	Interest	Total compound interest	Balance
1	£30.00	£30.00	£1,030.00
2	£30.90	£60.90	£1,060.90
3	£31.83	£92.73	£1,092.73

Looking at the AER allows you to compare different products.

AER stands for annual equivalent rate. This shows you what the rate would be if interest were paid and compounded each year.
Gross is the rate of interest paid before any tax (where applicable) has been deducted.

There are many benefits to compound interest, including:

Savings tips

For more tips and tricks that could help you save, check out our savings tips guide.

View our savings tips

Emergency fund guide

Want to learn more about saving for a rainy day? Our guide to building an emergency fund could help you to save a fund for life's unexpected expenses.

How to build an emergency fund

Do you pay tax on savings?

Find out more about the rules around the amount of tax you need to pay on savings and the account types which can help you to save more.

Learn about tax on savings

Compound interest FAQs

What's the best way to compound interest?

How does compounding work on investments?

With investments, the goal is to get a return on what you’ve invested.

The impact compounding has on this means you can get a return on your original investment, plus any earnings you’ve made too.

Remember, with investing there’s no guarantee you’ll get back the money you’ve invested.

What is compound interest on lending?

Feeling inspired to save?

Earning compound interest on your savings is just one of the ways you could grow your money.

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How does compound interest work?

What is compound interest?