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ISAs | 11th September 2018

Compound interest? What’s it all about?

Compound interest What’s it all about

We’re going to ask you to be honest. Do you know what compound interest means? If you don’t, you probably also don’t know how to make the most of it. You could be missing out on plentiful savings due to a misunderstanding of one small concept. We don’t want that to be the case, so we’ve provided this brief guide to help you understand how compound interest can either positively or negatively impact your finances.

What is compound interest?

Compound interest means you earn or pay interest on the amount of interest you amass. For example, when you take out a loan, the interest is calculated for the first period. This could be a month or a year. It all depends on what loan you’ve taken out. This interest is then added to the original total.

From this, the interest for the following period is calculated, but this time, it’s based on the combined figure from the first period – the original sum, plus the interest amount for the first period. As this continues each year, you pay more interest on your loan as time passes.

Interestingly, if you’re making regular payments on your loan, the overall compound interest you pay over time will be lower because the outstanding balance will be decreasing at each payment.

Your savings

While compound interest can be a pesky addition to your loans, it can be great for your savings and investments, helping you earn more.

Banks take compound interest into account when choosing your rate. They make things easier by calling it the annual equivalent rate (AER), which you may be familiar with after searching for the best deals. AER takes daily compound interest into account.

I don’t understand how AER works.

£1000 in your savings with 5% AER will take your total savings up to £1050. With compound interest, the next year, you will get 5% AER of £1050.

Making the most of compound interest when investing

It’s good to make sure you can find the best interest rate possible when looking to save. The highest interest rates often come from ISAs when saving. Keep in mind that some have bigger rates than others. You should look into the best type of ISA that will allow you to benefit from high compound interest without accepting too much risk to your money. But, stocks and shares ISAs differ in this aspect.

Stocks and shares ISAs don’t pay interest. But, if you invest wisely, you can still benefit from compounding. By this, we mean that you can use the dividends you receive on your investments to invest in more stocks from the holdings company. Then you’ll gain more dividends. Of course, you need to be careful with stocks and shares as there is no guarantee you’ll make a profit. The rising and falling of the stock market determine their value. If you do make a profit, it can grow year on year through compounding.

If you want to know more about which ISA is right for you, our easy-to-use comparison tool is the simplest way to compare the best savings options for you.

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