Compound interest overview
As Einstein once said “Compound interest is the eight wonder of the world” or something like that… and if you’ve ever wondered why some savings accounts grow faster than others, the answer is simple: compound interest. When it comes to Individual Savings Accounts (ISAs), understanding how compounding works can help you make smarter decisions and maximize your returns over time.
But let’s be real—financial jargon can be dry. So, let’s break this down into practical, real-life examples to show you exactly how compounding can make a big difference to your savings.
So, what is compound interest, really?
Think of compound interest as interest on top of your interest. Instead of just earning a fixed amount based on your initial deposit (simple interest), compounding allows your interest to grow exponentially over time. It’s money making more money for you.
Simple vs. Compound Interest: A Quick Example
Let’s say you deposit £10,000 into an ISA with a 5% annual interest rate:
- Simple Interest: You earn £500 per year (5% of £10,000), giving you £12,500 after five years.
- Compound Interest: In the first year, you earn £500. In the second year, instead of earning another £500, you earn 5% on £10,500, which is £525. Over five years, you’d have £12,763, a difference of £263 just from compounding.
Now, imagine what happens over 20 or 30 years—the difference becomes huge.
How do monthly ISA contributions boost your savings?
While compounding works wonders on a lump sum, the real magic happens when you add to your ISA regularly. By making monthly contributions, you increase the principal on which interest is calculated, leading to even greater returns over time.
Example: Adding to Your ISA Monthly
Let’s say you start with £1,000 and contribute £200 per month to an ISA earning 5% interest, compounded monthly:
- After 5 years: You’ll have £14,078
- After 10 years: Your balance grows to £32,799
- After 20 years: You’ll have a staggering £83,957
This is because each new deposit earns interest alongside the existing balance, causing your savings to snowball over time.
How does compound interest work in an ISA?
When you save in an ISA, compounding works differently depending on how often the interest is applied. Banks may calculate and add interest daily, monthly, or annually. The more frequently the interest is compounded, the faster your savings will grow.
Example
Let’s say you keep your £10,000 in an ISA with a 5% interest rate. Here’s what happens over 10 years, depending on how often the interest is compounded:
- Annual Compounding: £16,288
- Monthly Compounding: £16,470
- Daily Compounding: £16,486
See the difference? Daily compounding gives you a better return, even if only slightly. Over longer periods, the gap becomes even wider.
Why compounding matter more over time
Compounding is like a snowball rolling down a hill—it starts small, but the longer it rolls, the bigger it gets. The longer you keep your money in an ISA, the more compounding works in your favour.
Case Study: The Power of Starting Early
Let’s compare two savers:
- Emma starts saving at 25 and deposits £5,000 per year into her ISA for 10 years (total savings: £50,000). Then, she stops adding money but lets it compound at 5% annually.
- James starts at 35, saving £5,000 per year for 30 years (total savings: £150,000).
At age 65, here’s what they have:
- Emma: £540,000
- James: £370,000
Even though James saved three times as much, Emma’s money had more time to compound, so she ended up with a higher balance!
How to maximise compounding in your ISA
Now that you see how powerful compounding is, here are some practical ways to make the most of it with your ISA:
1. Start Saving as Early as Possible
Even if you start with a small amount, the key is time in the market, not timing the market. The sooner you start, the longer your savings have to grow.
2. Choose an ISA with Frequent Compounding
Look for accounts that compound daily or monthly, rather than annually, to maximise your growth.
3. Reinvest Your Interest
Some ISAs allow you to withdraw interest. But if you let it compound instead, your balance will grow much faster.
4. Make Regular Contributions
Adding money to your ISA regularly—whether monthly or annually—helps build your savings faster. Even small contributions compound over time and make a massive difference.
5. Use Your ISA Allowance Fully
Each year, you can put up to £20,000 into an ISA tax-free. The more you invest early, the more you can benefit from compounding.
6. Consider Fixed-Rate ISAs
Fixed-rate ISAs typically offer higher interest rates than easy-access ISAs. If you don’t need immediate access to your money, locking in a rate for 3-5 years can lead to stronger compound growth.
Final Thoughts
If you take just one thing away from this, let it be this: compounding is the key to growing your ISA savings efficiently. The earlier you start and the more regularly you contribute, the longer your money has to grow, and the bigger the results will be.
The smartest savers don’t just look at today’s interest rates—they think about the long game. Whether you’re saving for retirement, a home, or just a financial cushion, understanding compounding can make all the difference.
Resources on Compounding in ISAs
NatWest: What is Compound Interest
John is an experienced finance professional having been a financial advisor and city trader for over 15 years he attained his DIPFA in 2013 and has been advising millennial and Gen Z investors and savers on ISAs, investment portfolios and personal savings in the UK.