Compound interest: what it is and how it works

What is compound interest?

Compound interest in investing refers to the process of reinvesting profits from your share dealing positions, dividends – or even successful trades – to generate extra returns. This creates a snowball effect, where your initial position grows not only from its original value but also from the accumulated interest or profits over time.

Senior technical analyst Axel Rudolph gives his view on the power of compound interest

Compound interest is one of the most powerful concepts in finance. It refers to the interest that accrues on the original principal amount invested and also on the accumulated interest from previous periods.

Over long periods of time, compound interest can lead to exponential growth and generate significant wealth. Understanding how it works is key for anyone looking to build long-term wealth through investing.

Compound interest example

Let’s take a simple example to illustrate the power of compound interest. Suppose you invest £10,000 in stocks that deliver an average annual return of 7%. In the first year, you’ll earn £700 in interest so your account balance will grow to £10,700. In the second year, you’ll earn interest not just on your original £10,000 but also on the £700 interest that was reinvested. This will lead to £11,449 in your account by the end of year two. By allowing your returns to compound over many years, your initial £10,000 could easily grow to over £40,000 in 20 years and over £80,000 in 30 years.

Now, let’s compare this to putting your money in a savings account at a bank that pays 4% annual interest. With £10,000 invested at 4% annually, you’ll have £10,400 after the first year and £10,816 after the second year. Your £10,000 will grow to around £22,226 after 20 years and £33,135 after 30 years.

After 30 years, the savings account compound interest return is less than a third of a comparable investment in a global stock index such as the US Standard & Poor's 500 (S&P 500). On average, it has a 7% annual return on investment since inception.

For the 10 years ending 31 December 2023, the S&P 500 had an annual compounded rate of return of 15.2%, including reinvestment of dividends, at a time when savings accounts in the UK hardly offered any return. Of course, the actual rate of return is largely dependent on the types of investments you select.

The key takeaway is that compound interest thrives when two ingredients are present: time and higher rates of return. This is why investing in the stock market over the long term tends to deliver the highest returns compared to other, more conservative, investments.

Let’s take a real-life example. If you had invested £10,000 in the S&P 500 index of large US stocks 30 years ago and reinvested all dividends, your investment would have grown to around £210,000 today. Even adjusting for inflation, that £10,000 would be worth over £100,000 in today’s money thanks to the power of long-term compound growth.

Compound interest and simple interest differences

The main difference between compound interest and simple interest lies in how the interest is calculated and reinvested:

• Simple interest is calculated only on the principal amount. If you invested £10,000 at 5% simple interest for five years, you'd earn £2,500 in interest (£500 per year)

• Compound interest is calculated on the principal and the accumulated interest from previous periods. Using the same example, with annual compounding, you'd earn £2,762.82 in interest over five years

Compound interest can be more powerful as it enables your profits to generate additional profits over time.

Compound interest pros and cons

How is compound interest calculated?

Calculating compound interest involves several factors:

Principal amount

The principal is the initial sum of money used to invest, which is used to calculate the interest. In other words, this would be your starting capital. The principal may increase or decrease depending on any deposits or withdrawals.

Return

The higher the rate of return, the more money you'll receive as interest.

Duration

The duration is the length of time for which the money will be used in your investment, which may be a fixed period or open-ended. The longer the period, the higher the return due to the power of compounding.

Frequency of compounding

Your returns can be compounded daily, monthly or annually. The more frequent the compounding, the more rapidly the balance will grow. This could be how often you reinvest your profits.

To understand compounding better, it's also worth learning about the difference between APR, AER and APY:

Annual percentage rate (APR)

This is the annual rate of interest payable on mortgages, loans, credit cards and other borrowings on a simple interest basis. It includes any upfront fees in addition to the interest charge, spread over the duration of the loan.

Annual equivalent rate (AER)

The interest or return earned on investments, taking into account how often interest is paid on a simple interest basis.

Annual percentage yield (APY)

The interest or return earned on investments on a compound basis. This is a better indication of returns than AER if you do not intend to make any withdrawals.

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¹ Based on revenue (published financial statements, 2023)
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