How compound interest works
Compound interest is interest earned on interest. Each time your balance compounds, the new interest is added to your principal, so the next round of interest is calculated on a bigger pot. It's the mechanism behind every wealth-building strategy, from cash ISAs to global index funds — and the reason Albert Einstein reportedly called it the eighth wonder of the world.
The effect starts slow and accelerates. £10,000 at 5% earns £500 in the first year, £525 in the second, £551 in the third — each year a bit more than the last. After 10 years, the balance is about £16,289; after 20 years, £26,533; after 30 years, £43,219. Add a modest £200 a month and the 30-year figure becomes over £205,000 — of which more than half is interest the contributions earned over time.
The biggest lever is time. Starting 10 years earlier typically doubles the final balance at the same contribution rate. That's why financial advisers talk so often about starting retirement savings in your twenties rather than your thirties — those extra years of compounding are disproportionately powerful.
Simple vs compound interest
Simple interest pays you a fixed percentage of your original deposit each year — the interest is withdrawn or spent, never reinvested. On £10,000 at 5%, simple interest pays £500 every year forever. After 30 years, you've earned £15,000.
Compound interest reinvests the earnings. On the same £10,000 at 5% for 30 years, the final balance is around £43,219 — more than double what simple interest would give you. The difference is exclusively from interest-on-interest.
| Years | Simple interest | Compound interest | Compounding premium |
|---|---|---|---|
| 5 | £12,500 | £12,763 | £263 |
| 10 | £15,000 | £16,289 | £1,289 |
| 20 | £20,000 | £26,533 | £6,533 |
| 30 | £25,000 | £43,219 | £18,219 |
The rule of 72
A handy mental shortcut: divide 72 by your annual interest rate to estimate how many years it takes your money to double. At 4%, money doubles in about 18 years; at 6%, about 12 years; at 9%, about 8 years. The formula works best for rates between 2% and 10%, where it's accurate to within a few months. It's a good sanity check when you see ambitious long-range projections — if a pension or investment claims to double every 4 years, that would require an 18% annual return, which is rarely sustainable.