Put £1,000 into a savings account and earn interest. Next year, you may earn interest on both your original £1,000 and the interest already added. That is compound interest.
It can help savings grow over time, but the same principle can increase borrowing costs when unpaid interest is added to a debt. Here is how compounding works, what the numbers mean and how to compare UK savings accounts.
What Is Compound Interest and How Does It Work?
What is compound interest?
Compound interest is interest calculated on the starting balance plus interest that has previously been added. The amount you earn in one period becomes part of the amount that may earn interest in the next.
Imagine you deposit £1,000 at a hypothetical fixed rate of 5% per year, with interest added annually:
- Year 1: 5% of £1,000 is £50, making the balance £1,050.
- Year 2: 5% of £1,050 is £52.50, making the balance £1,102.50.
- Year 3: 5% of £1,102.50 is £55.13 when rounded to the nearest penny, bringing the balance to about £1,157.63.
By year two, £2.50 of that year’s interest comes from earning interest on the first year’s £50. That extra growth is what distinguishes compounding from simple interest.
Compound interest versus simple interest
With simple interest, the interest calculation stays tied to the original principal. With compound interest, accumulated interest can be added to the principal and included in later calculations.
| After 10 years on £1,000 at 5% | Simple interest | Compound interest |
|---|---|---|
| Annual calculation | 5% of the original £1,000 | 5% of the growing balance |
| Total balance | £1,500.00 | £1,628.89 |
| Total interest | £500.00 | £628.89 |
In this mathematical example, compounding earns £128.89 more over ten years. Both scenarios assume a constant rate, annual interest periods, no additions or withdrawals, and no fees or tax.
How much could £1,000 grow over time?
The difference becomes more noticeable over longer periods. Assuming a constant 5% rate compounded annually:
| Time invested | Illustrative balance | Interest earned |
|---|---|---|
| 1 years | £1,050.00 | £50.00 |
| 5 years | £1,276.28 | £276.28 |
| 10 years | £1,628.89 | £628.89 |
| 20 years | £2,653.30 | £1,653.30 |
| 30 years | £4,321.94 | £3,321.94 |
For example, after 20 years the balance would be around £2,653.30, including roughly £1,653.30 of interest. These are illustrations, not current advertised savings rates or investment forecasts. Real accounts may have variable rates or terms that change the outcome.
How is compound interest calculated?
For a fixed nominal annual rate compounded at regular intervals, the standard formula is:
A = P × (1 + r/n)nt
- A = ending balance
- P = starting balance
- r = annual interest rate as a decimal (5% becomes 0.05)
- n = number of compounding periods per year
- t = number of years
For annual compounding, n = 1, so £1,000 after 10 years at 5% is £1,000 × (1.05)10 = approximately £1,628.89. This basic formula assumes no regular deposits, withdrawals or changes in rate.
Does daily or monthly compounding make a difference?
It can. If the same nominal annual rate is applied, adding interest more frequently can increase the effective annual return slightly. However, real accounts use different calculation and payment rules. An account that calculates interest daily may only pay it monthly or annually; the timing of when interest is credited matters.
That is why UK savers should compare the AER, rather than choosing an account simply because it says interest is calculated daily.
What does AER mean on a UK savings account?
AER means Annual Equivalent Rate. It shows what the interest rate would be over a year if interest were paid and compounded once a year, making savings offers easier to compare on a consistent basis. For example, an advertised 5% AER does not necessarily mean a 5% nominal rate paid every month.
Compare AER with AER, but also check whether the rate is fixed or variable, whether an introductory bonus ends, whether withdrawals are restricted, and whether interest is paid away rather than retained in the account. The Financial Conduct Authority and MoneyHelper’s explanation of savings interest provide useful context.
How do regular deposits affect compound growth?
Adding money changes the calculation. Suppose you start with £1,000 and then save an extra £50 each month. The final amount depends on when each deposit arrives, the actual interest rate and how the account calculates and credits interest.
Unlike the simple £1,000 example, your eventual balance would be made up of your contributions plus interest earned on those contributions. When comparing savings plans, separate the money you personally put in from interest earned so you can see what caused the growth.
Saving for a specific purchase? Our guide to sinking funds explains how to set money aside for known future expenses.
Can compound interest increase debt?
Yes. If a borrowing agreement allows interest to be added to an outstanding balance, future interest may be calculated on a larger amount. But not every debt compounds in the same way: credit cards, overdrafts and loans have distinct charging rules, repayment terms and potential fees.
For example, if a hypothetical £1,000 debt attracted 10% annual interest and no payments were made, annual compounding alone would produce £1,100 after one year and £1,210 after two years. This is a deliberately simplified calculation, not a description of how a particular UK credit card or loan operates.
When borrowing, look at the total repayable, payment schedule and relevant APR, rather than comparing the borrowing rate directly with savings AER. For more context, see what an overdraft is and how it works.
Is compounding the same as investment growth?
The underlying idea is similar: if investment gains or dividends are reinvested, they can contribute to future returns. But investment returns are not fixed or guaranteed. Markets may fall, and reinvested losses or fees can affect the outcome. A table assuming steady 5% annual growth is appropriate for explaining the maths, not predicting what an investment will earn.
Does inflation reduce the benefit of compound interest?
Inflation can reduce what your savings will buy, even while the number of pounds in your account increases. As an illustration, if £1,000 earns 3% over a year it becomes £1,030. If the price of the goods you want rises 5% over the same period, your balance has grown but your purchasing power has fallen.
It is helpful to distinguish nominal growth (more pounds) from real growth (growth after inflation). Read our explanation of what inflation is and why prices rise. MoneyHelper also explains how inflation affects savings.
Five things to check before choosing a savings account
- AER: compare like-for-like annual equivalent rates.
- Fixed or variable: find out whether the provider can change the rate.
- Access: check notice periods, withdrawal limits or penalties.
- Interest payment: see whether it stays in the account to compound or is paid to another account.
- Terms and protection: review the provider’s conditions and applicable deposit-protection arrangements.
The highest headline rate is not automatically the most suitable account if you need frequent access or the rate only applies for a short period.
Frequently asked questions
What is compound interest in simple terms?
It is interest earned on your original savings plus interest already added to the balance.
What is the difference between AER and APR?
AER helps compare annual returns on savings. APR helps compare the annual cost of borrowing, including certain charges. They describe different products and should not be treated as interchangeable.
Does compound interest work every month?
It can, but frequency and calculation rules depend on the account. Some providers calculate interest daily but credit it less often.
Does compounding guarantee that savings beat inflation?
No. Your nominal balance may grow while rising prices reduce its purchasing power.
Can compound interest work against me?
Yes. Some debts can accrue interest on amounts that include earlier interest, depending on the terms and repayments.
The bottom line
Compound interest means interest can earn further interest. Time, rate, additional deposits, withdrawals, fees and tax all affect the result. To judge a real UK savings account, use its AER and terms; to understand borrowing, check the APR, repayments and total cost.
Further reading: MoneyHelper — Interest rates explained; FCA — Cash savings research and AER definitions.
This article is for general education, not personalised financial advice. Rates and account terms can change.