What is compound interest?

Whether you’re thinking of putting aside money for a house, retirement or just a rainy day, you’ve probably been told that the sooner you start, the better. And it’s true. The more time you give yourself, the better the chance you’ll have of achieving your goals. But the reason behind this is not just that you’ll have more pay cheques coming in from which to save. It’s also because you’ll give your money more time to grow. 

For example, if you invest £1,000 and receive annual interest (also called ‘annual returns’) of 7%, you’ll have £1,070 waiting for you at the end of the first year. Nothing to sneeze at, but hardly life-changing. However, it’s when you leave your money invested for longer that the interest becomes more… interesting. That’s because it’s not just your initial investment that has the potential to generate returns. The interest on your interest – known as compound interest – can also generate returns.

How to calculate compound interest 

Using the same example, you might think the £1,070 you have at the end of year would grow to £1,140 after year two. But it could grow to nearly £1,145. That’s because your £70 return potentially generated almost £5. The same initial investment could grow to almost £2,000 after 10 years and over £5,400 after 25 years.

Now that’s nice! But you know what might be even nicer? How about if you decided to continue investing money every year. What could happen then? Well, assuming you:

• had the same initial investment
• saw annual returns of 7%
• contributed an extra £1,000 at the end of each year 

your investments could be worth over £68,000 after 25 years. 

Of course, these numbers are for illustrative purposes only. The value of an investment isn’t guaranteed and will go down as well as up, and you may get back less than the original amount you invested.

Is compound interest taxable?

If you invest via an ISA, any potential gains are tax-free – meaning you don’t pay tax on compound interest. So you get to keep more of your hard-earned cash. Put simply, the interest on your interest really matters, and its power tends to grow over time. So while the best time to get started with investing may have been a long time ago, the second best time could be today.

Could your future be nicer with an ISA? Well, that depends on whether you believe the potential sums of money illustrated above would make a huge difference to what you could do in life. We certainly believe they would. And Albert Einstein would be proud of you!

If you like to learn more about investing, here’s a link to all our ISA articles.