What is compound interest?

Compound interest is one of the main ways that your investments could grow over time – and, even better, it may help power your savings without you putting in any extra cash. This concept applies not just to savings but also to debt, so it’s important to understand what it means.

Compound interest refers to the concept that interest applies, not just to the initial amount that you invested, but also to the interest that has previously been earned. For this reason, it’s often called ‘earning interest on interest’.

For example, if you saved £5,000 with an annual interest rate of 5%, at the end of one year you would have £5,250 – a return of £250. At the end of two years, you would have £5,512.50 – 5% of the original £5,000, plus 5% of the £250 you earned in year one. The interest compounds in this way every year, meaning as long as you don’t take any money out, your savings could continue to grow – and grow faster – over time.

Compound interest example with an annual interest rate of 5%: £5,000 saved, with no withdrawals

• Initial investment: £5,000

- Year 1: £5,250

- Year 2: £5,512.50

- Year 3: £5,788.13

- Year 4: £6,077.53

- Year 5: £6,381.41

- Year 6: £6,700.48

- Year 7: £7,035.50

- Year 8: £7,387.28

- Year 9: £7,756.64

- Year 10: £8,144.47

• Total interest earned: £3,144.47

While compound interest can be hugely valuable for savers, it also applies to interest paid on debt. When you make repayments on a loan, you pay interest not just on the original amount that you borrowed, but also on the interest that has already accrued. In the same way that compound interest means your savings can grow without additional deposits, it also means your debts can grow without additional borrowing.

Compound interest vs compound returns

While compound interest refers to interest earned on a loan or savings account, a similar concept applies to other kinds of investments – known as compound returns.

People invest their money with the hope of making a profit, also known as a return. When that profit is re-invested, it could earn a profit, too, meaning the returns are compounded.

For example, an investor might invest their money in shares of a company. If that company pays dividends to its shareholders, those dividends can be re-invested as they are paid and may earn returns, too. Many investment platforms allow savers to re-invest their dividends automatically and potentially benefit from compound interest.

How to receive compound returns

Compounding returns could be one of the most powerful ways to grow your savings without having to add to them. There are three ways to improve your likelihood of receiving compounding returns:

• Invest often. Compounding relies on you re-investing any returns back into the investment, rather than withdrawing them. As a result, it’s important to invest often in assets that offer consistent returns and easy re-investment.

• Invest early. Because compound returns happen over time, starting early could make a difference. A small, well-chosen investment today may grow over time, starting the compounding process.

• Diversify. Compound returns only happen when your investments are making a profit. Diversified portfolios typically perform better than undiversified ones, as they can often better withstand market ups and downs, so it may be helpful to spread your investments across different asset classes, geographies or sectors to aim to improve your chances of making returns.

Choosing to invest can feel like a complex decision, one you may be inclined to put off for a later date. However, compound interest and returns are one of the many reasons to start your investment journey as early as possible – both to get your debts under control, and to power your savings. Remember though that investing can be risky. The value of your investments and the income from them can fall and are not guaranteed so you might not get back your initial investment.

At Schroders Personal Wealth, we specialise in personalised financial advice to help identify which investment options may be right for you, considering not just compound returns but also your broader financial goals, needs, and your ability and willingness to accept risk.

One of our principles is that we believe in the importance of regular advice reviews. This helps your adviser make sure your financial plan stays relevant even as your circumstances change. All meetings with our financial advisers are free up to and including the presentation of your financial plan. There is no financial commitment required until you decide to take up any of our recommendations.