Compound interest and savings: what you need to know

Will you earn more from daily, monthly or annual interest?

The magic of compound interest helps your money grow even when you’re not adding money to your savings. But what is it and how does it work?

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What is compound interest?

In a nuthsell, it’s the interest you earn on your interest.

The magic of compounding means that whenever the interest is added to your account – which is most likely to be daily, monthly, quarterly or annually – it has the potential to create its own returns. 

So let’s take an example. Say you stick £1,000 in an account that pays 4.5% interest into your account at the end of a year. After the first year, you’d earn £45 in interest so you’d have £1,045 in total. So far, so simple. 

With the interest added to your savings, the following year (assuming you got the same rate) you’d earn 4.5% on the new balance of £1,045 – that’s interest on your savings and interest on the interest. This would add up to around £47 giving you a total of just over £1,092. And so the pattern continues.

If you’re more of a visual person, there’s a popular analogy that helps explain compounding.  Imagine a snowball rolling down a hill. It starts off small and as it picks up more snow, it grows bigger in size – as does your money. 

Or, here’s a table below to show how it might work:

Year	Balance at start of the year	Annual interest earned
1	£1,000	£45
2	£1,045	£47.03
3	£1,092.02	£49.14
4	£1,141.17	£51.35
5	£1,192.52	£53.66
Total	£1,246.18

AER vs gross interest rates

Compounding is why you often see two different rates of interest advertised. Gross is the amount added to your balance, while AER (Annual Equivalent Rate) is what you’d earn when compounding is factored in over 12 months.

Sometimes these two rates will be the same. So, if you had £1,000 in an account that pays 4.5% gross, at the end of the year you’d earn £45 in interest giving you £1,045 in total. So the AER is the same at 4.5%.

But if interest is paid more than once a year (monthly or quarterly, for example) and can keep compounding, the AER will be higher than the gross rate.

So if you were paid interest monthly, that 4.5% gross interest payment each month would be earning interest too. And as a result the AER would actually be closer to 4.59%, earning you £45.90 over the year.

If it was paid daily, then there are more opportunities for it to compound, so the AER on that account would be 4.6% – so not a huge difference to the monthly interest payment, but it shows how it works

That’s why, when you’re comparing savings rates, you always want to look at the AER rather than the gross rate.

When will interest not compound?

Most savings accounts will compound your interest. But there are some exceptions.

Accounts that “pay away” interest

Watch out for accounts that ‘pay away’ interest – usually longer-term fixed bonds. These require you to have a nominated account where the interest is moved into, rather than added to your balance, which means you won’t benefit from compounding. 

That’s not necessarily a bad thing. 

If you’re fixed for a long time and are worried about the interest you earn over a number of years taking you over your tax free personal savings allowance, paying the interest away each year, rather than getting it at the end of the term, could help you keep within your allowance or reduce the amount of tax you pay.

Accounts with interest on limited balances

There are also savings accounts which limit how much you can earn the advertised rate on. If you have the full amount allowed in the account, when the interest is added above that balance it won’t earn interest, so it won’t compound.

For example, the Santander Edge Saver pays 6% AER on savings up to £4,000 and the Barclays Blue Rewards Rainy Day Saver pays 5.12% AER up to £5,000.

Let’s look at the Santander Edge Saver in more detail. If you put an amount lower than the limit into the account, say £3,000, you’d earn about £180 in a year, which reflects that headline 6% AER rate.

But if you put in the full £4,000 you’d earn £233ish over a year. That is the lower 5.84% gross interest rate as the interest can’t compound.

Of course, if you move those monthly interest payments each month to another account paying interest, they’ll have the opportunity to compound, but you do need to move them.

Accounts that mature

You might also not benefit from continued compounding if you opt for an account that only lasts for a short time at the advertised rate.

Once the term has ended, all the money is then moved to a different account that’ll pay far less, if anything at all. So you’ll need to move your money elsewhere to continue getting a better rate – and earn interest on the interest already earned.

Should I get my interest paid daily, monthly or yearly?

This is a good question – and one we hear a lot at Be Clever With Your Cash.

Most banks will pay interest each month or each year, and in some cases, as with Trading 212, you’ll get it added to your account daily.

Technically, daily is better than monthly, which is better than annual, as the more frequent payments have more time to compound. However, as a result, if you look at gross rates, you’ll see the best rates are probably for annual payments.

But remember, the AER shows you what you’ll earn after a year including any compounding regardless of when the interest is paid. So it won’t make a difference when you’re paid the interest when you’re comparing rates over a year.

So really, when you want the interest paid really comes down to when you want access to the money, assuming those AERs are the same. Some people prefer monthly interest payments because they like having a regular income.

Of course, if you do spend some of the interest during the year it can’t compound, so you’ll effectively be getting the lower gross rather than AER.

Can you earn compound interest on a Cash ISA?

Yes you can – and with ISAs you don’t need to worry about exceeding your PSA because the earnings are all tax-free.

How can I calculate compound interest?

Pretty much every account you see will list the AER so you don’t need to work out the compound rate yourself. But just in case, and if you’re a maths head, you can use the simple(!) equation: A = P(1 + r/n)nt

Be sure to use the below formula:

• A = final amount
• P = initial ‘principal’ balance
• r = interest rate
• n = number of times interest is applied per time period
• t = number of time periods elapsed

And if you’re not, you can use an online calculator like this one from The Calculator Site to work out how much you could earn on your savings with compounding. The AER calculator from Optimly helps you compare savings accounts that have different terms.