Compound interest grows faster when compounding happens more frequently. This surprises many people — surely the annual return is what matters? But the frequency of compounding determines how quickly earned interest begins earning its own interest, and over long periods this difference adds up.
Consider £1,000 invested at 12% annual interest. With annual compounding (interest added once a year), after one year you have £1,120. With monthly compounding (interest added each month at 1% per month), after one year you have £1,126.83. With daily compounding, you have £1,127.47. The difference after one year is small. After 20 years, it becomes more meaningful.
The formula that captures this is the effective annual rate (EAR), which converts any compounding frequency into an equivalent annual rate. A 12% rate compounded monthly has an EAR of 12.68% — because you are earning 1% per month on a balance that grows each month.
For savings accounts and bonds, this matters when comparing products. A savings account offering 5% compounded quarterly is slightly better than one offering 5% compounded annually, all else equal. Always compare EARs, not nominal rates.
For borrowers, the same mechanics apply in reverse. A credit card with a nominal rate of 20% compounded daily actually charges an EAR of around 22.1%. This is why APR (Annual Percentage Rate) regulations exist — to force lenders to disclose the true effective annual cost of borrowing in a standardised way.
For long-term investors in stock markets, the practical impact is that dividends reinvested continuously compound at the market's rate of return. The more frequently dividends are reinvested (monthly vs annually), the faster compounding works.
The honest conclusion: for most retail investors, differences in compounding frequency are less important than differences in rate (choosing better investments or lower fees) and time horizon (staying invested longer). But understanding compounding frequency helps you compare products accurately and avoid being misled by nominal rates.