By: Stella Demades, Product Director at OakNorth Bank
In the words of Albert Einstein, “Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Einstein believed that those who used compound interest to their advantage were able to reap the benefits in the long-term – think 10, 20 or even 30 years.
In this piece, I’ll share how you can unlock the secret to successful savings through compound interest, what it is and how it can help you earn a higher return on your savings.
What is compound interest?
Compound interest is the interest calculated on the initial principal, which also includes all of the accumulated interest on previous periods of a deposit or loan. In layman’s terms its interest accrued on top of interest.
How does compound interest work?
To grasp the full potential of compound interest, first you need to think about simple interest – you deposit a lump sum in your bank and your bank will pay interest on top of that deposit. For example, if you deposit £10,000 at 1.60% interest rate, you’ll have only made £160 on top of your initial £10,000 deposit (total of £10,160).
To give you an overview of how compound interest works let’s take a look at two examples – the OakNorth Easy Access Deposit Account and our 12-month Fixed Term Deposit.
For those who don’t know what an Easy Access Deposit Account is, it’s a savings account that traditionally pays higher interest than a typical account. It also gives you the flexibility to withdraw cash from the account at any point in time.
Now let’s take a look at how compound interest will work with an EA account – see table below:
|Year 1||Year 2||Year 3|
|Deposit||£10,000||£10,000 (Y1 + Y2 = £20,000)||£10,000 (Y1 + Y2 + Y3 = £30,000)|
|0.40% gross interest||0.40% of £10,000 = £40||0.40% of £20,040 = £80.16||0.40% of £30,120.16 = £128.48|
|Total by year end||£10,040
(£10,000 + £40)
(£20,040 + £80.16)
(£30,120.16 + £128.48)
*The exact amount differs depending on your circumstances and deposit dates
Another great example is our 12-month Fixed Term Deposit (FTD). If you deposit £70,000 at 1.60% annual equivalent rate (AER), then by the end of year one, you will have accumulated around £1,120 in interest. If you were to leave this for 10 years (and let compound interest work its magic), you will end up with a total amount of £82,041.79, which roughly equates to £12,041.79 in compounded interest.
Here’s a visual representation of how compound interest can help you accumulate more savings over time vs simple interest:
You can also use a compound interest calculator to gain a full picture of how your overall savings portfolio will grow over time.
What are the best ways to benefit from compound interest?
One of the best ways to get more out of compounding interest is time. The longer you can keep your cash in a savings account, the more time to let compound interest work its magic and exponentially grow.
Another way to benefit is through interest rates. When looking to grow your savings it’s vital to compare products and look for the best possible interest rate on the market. Having a higher interest rate will ultimately help your savings grow even faster.
As you can see, compound interest can substantially impact your overall savings. With a little bit of time and patience, you could see the significant benefits down the line – your future self will thank you!