How compound interest works

Simple vs compound interest

Simple interest is paid only on your original deposit. Put £1,000 in at 5% and you earn £50 a year, every year — £500 over ten years.

Compound interest is paid on your deposit and on the interest already earned. Year one you earn £50, taking the balance to £1,050. Year two you earn 5% of £1,050 — £52.50. Each year the base grows, so the interest grows too. This snowball effect is what makes compound interest so powerful over long periods.

Why time matters more than amount

The longer money compounds, the more of your final balance comes from interest rather than your own deposits. In the early years, growth is modest. But because each year builds on the last, the later years add far more. This is why saving £100/month from age 25 can end up worth more than saving £200/month from age 40 — the early money simply has more time to compound.

What is AER?

AER (Annual Equivalent Rate) is the standardised rate UK savings accounts must show. It includes the effect of compounding within the year, so you can compare accounts fairly regardless of whether they pay interest monthly or annually. An account paying 4.9% monthly and one paying 5% annually might have the same AER. Always compare on AER, not the headline rate.

How often interest compounds

Interest can be added monthly, quarterly or annually. More frequent compounding means slightly more growth, because interest starts earning interest sooner. The difference is small but real — monthly compounding at 5% gives a true annual return of about 5.12%.

UK tax on savings interest

Most savers pay no tax on interest, thanks to the Personal Savings Allowance (PSA):

Interest above your PSA is taxed at your normal income tax rate. With higher savings rates in recent years, more savers are exceeding the allowance than before.

ISAs: tax-free saving

A Cash ISA lets you earn interest completely tax-free, regardless of the PSA. For 2026/27 the ISA allowance is £20,000 per tax year. Note that from April 2027, the cash ISA limit is due to fall to £12,000 for those under 65 — so the current year is the last with the full £20,000 cash allowance for younger savers.

Don't forget inflation

Compound interest grows your money in cash terms, but inflation erodes its spending power. If your savings earn 4.5% but inflation is 3%, your real return is only about 1.5%. To genuinely grow wealth, you want a rate that beats inflation. This is also why some people consider investing (which carries risk) for very long-term goals, rather than cash savings alone.

Try the calculator

Use our savings calculator to see how an initial deposit plus regular monthly saving grows over time with compound interest. Adjust the rate and term to see how much of your final balance comes from interest rather than your own deposits.

For pension-specific saving, see our pension calculator, which adds tax relief and employer contributions to the same compound-growth idea.