When it comes to growing your savings, there’s a formula you can use to your advantage: compound interest.
What is compound interest?
Essentially, it’s ‘interest on interest’. Say you set £10,000 aside in Starling’s Cash ISA, which has an interest rate of 2.50% AER (2.46% tax-free)*. For our ISA, we calculate interest daily and pay it monthly, which means your money ‘snowballs’.
Just like a snowball rolling down a hill, picking up momentum and growing over time, your original sum increases – without any additional effort from you. How? Because you earn interest both on your original £10,000 and on the interest you’ve earned since setting your £10,000 aside.
How does compound interest differ from simple interest?
Compound interest and simple interest use different formulas. Compound interest is calculated on an initial deposit (known as the principal) and any interest that’s accumulated since the deposit was made.
Simple interest is only calculated on the principal – no ‘interest on interest’.
Here’s what the difference could look like for your money:
Interest rate: 2.50% AER (2.46% tax-free)
Initial deposit: £10,000
Balance if interest is earned and added monthly – compound interestBalance if interest is earned and added annually – compound interestBalance if interest is earned annually, then removed – simple interestYear 1£10,252.88£10,250.00£10,250.00Year 2£10,512.16£10,506.25£10,250.00Year 3£10,778.00£10,768.91£10,250.00Year 4£11,050.56£11,038.13£10,250.00Year 5£11,330.01£11,314.08£10,250.00
In the table above, we’ve assumed that no extra money is added after the initial deposit has been made. For the account where interest is paid annually, we’ve assumed that the interest earned is taken out each year and therefore does not compound either monthly, or annually.
