Understanding Compound Interest and How It Can Grow Your Savings

Understanding Compound Interest and How It Can Grow Your Savings

If you have been looking into saving money and boosting your finances, you will probably have come across the phrase “compound interest.” It’s a term that’s often thrown around in the financial world, especially when it comes to getting the most out of your savings. But, how much do you know about what compound interest is and how it works? Below, IQ Money have taken a look at the ins and outs of compound interest, and how it can give your savings a much needed push in the right direction.

What is Compound Interest?

To get the most out of compound interest, you need to know what it is. When you put money into a savings account - as long as you have chosen an account which pays interest - you will slowly see your money grow. This is because interest is calculated based on how much money you have saved and then it’s added to your total. When people talk about compound interest, they are referring to interest that’s calculated based on the total amount of money in your account, which also includes all of the interest that you have accumulated so far. 

Instead of the interest being paid just on the amount that you have paid into the account - for example, the percentage of your income that’s put away for a rainy day, or a lump sum that you’ve been gifted by a loved one - it’s calculated on every penny that’s in there, which includes any previous compound interest. This means that you are earning interest on your interest, which can give your savings a significant boost. Depending on the specific savings account that you have, compound interest will be paid daily, monthly, quarterly or annually. Each time compound interest is added to your savings, it increases the amount of money that the next lot of compound interest will be calculated on.

How Does Compound Interest Boost Savings?

Compound interest can significantly enhance the growth of your money over time, making it an effective savings tool. Whether you are putting a little bit of money aside each month, or you have a lump sum that’s being saved for a big purchase, compound interest is a way to add even more money to your pot, without doing anything. It boosts your savings by earning interest on previous interest. You don’t just get interest on the money that you’ve put into the account from your own money, you also get interest on any interest that’s been added previously.

When you first deposit money into a savings account, it earns interest based on how much you have in there. At the end of each compounding period, the interest you have earned is added to the total amount in the account. In the next compounding period, interest is calculated again, but this time on the new amount. This now includes any previously earned compound interest. This cycle continually repeats and your total grows each compounding period, and so the amount of interest earned also increases.

The Benefits of Compound Interest

Compound interest isn’t something to overlook, as it can make a big difference to your savings efforts. There are a lot of benefits that come with focusing on compound interest when you’re saving money, such as:

Savings Growth - With compound interest, long term savings goals are key. The longer that you leave your money in the account, and the longer you leave compound interest to accumulate, the more you will benefit. This means that the growth possibilities are endless, as compound interest will continually be added, month after month, year after year.

Advantage of Time - Compound interest grows over time, so starting your savings journey early gives you a big advantage. This is because your money has more time to compound, which leads to bigger results in the long run. The sooner you begin to save money, the sooner compound interest can start to build up. 

Motivation - Once you start to see the benefits of compound interest, and how your savings pot is growing, it’s a lot easier to stay motivated to continue on. Compound interest can motivate you to save more money and more often, whilst also helping you to resist any urges to withdraw your funds early. When you see compound interest quickly adding up, you’re more likely to keep your funds in the account. 

How to Maximise Your Compound Interest

One of the great things about compound interest is that it takes care of itself. You can focus on other things, knowing that your compound interest is slowly building up in the background. You don’t need to calculate anything yourself, as it’s all done passively behind the scenes. But, that doesn’t mean that you can’t maximise your compound interest. 

Start Saving Early - To maximise your compound interest and grow your savings as much as possible, you need to start saving early. The sooner you start saving, the more time your money has to accumulate compound interest. When it comes to compound interest, time really is a key factor in increasing your savings by as much as possible.

Make Regular Deposits - There’s nothing wrong with adding a lump sum into a savings account and watching the interest grow, but consistently adding to your savings will boost the total amount in there, which leads to more compound interest. The more you have saved, the higher your compound interest will be. 

Choose the Right Account - There are a lot of savings accounts out there but, if you want to maximise your compound interest, you should choose one with a high interest rate. This ensures that you are getting the maximum return on your money. Choose a savings account that has competitive interest rates and frequent compounding periods, as this will ensure that your savings will begin to grow as soon as possible. 

How does Compound Interest Rate work in practice?

Imagine you have £2,000 and you decide to invest it with an annual interest rate of 5%. Let’s see how your money grows over the next three years with compound interest!

Year 1: Watching Your Money Grow

You start with £2,000. After one year, with a 5% interest rate, your investment grows. Here’s the magic formula in action:

New Amount=£2000×1.05=£2100

Wow! After just one year, your £2,000 has grown to £2,100. Not bad for doing nothing but letting your money work for you!

Year 2: The Growth Continues

Now, your new starting amount is £2,100. Let's see what happens after the second year:

New Amount=£2100×1.05=£2205

Look at that! By the end of the second year, your investment has increased to £2,205. Your money is growing faster and faster!

Year 3: Reaping the Rewards

Finally, we move into the third year. Starting with £2,205, here’s what you get:

New Amount=£2205×1.05=£2315.25

After three years, your initial £2,000 has blossomed into £2,315.25. That’s an extra £315.25 just from the interest!

The Journey of Your Investment

Initial Amount: £2,000

After 1 Year: £2,100

After 2 Years: £2,205

After 3 Years: £2,315.25

By simply allowing your money to grow with compound interest, you’ve significantly increased your investment. It’s a powerful reminder of how saving and investing can benefit you over time. Imagine what could happen if you let it grow for even longer!

What do you think? 

At IQ Money, we know that money can be confusing, especially when it comes to compound interest, growing your savings and maximising your returns. Thankfully, with our insights and knowledge, navigating the financial world is a lot easier. Read more on the blog to learn about savings interests, payment wallets and more.