Simple interest vs compound interest
With simple interest, you earn interest only on your original deposit. Put £10,000 in an account paying 5% simple interest, and you earn £500 every year — the same amount, year after year. With compound interest, each year's interest is added to the balance, and the following year's interest is calculated on the new, larger amount. The difference seems small at first, but over decades it becomes enormous.
The rule of 72
The Rule of 72 is the simplest way to understand compounding: divide 72 by the annual interest rate to find approximately how many years it takes to double your money. At 6%, your money doubles every 12 years. At 9%, every 8 years. At 3% (a typical savings rate), every 24 years. The rule makes clear why a higher return dramatically accelerates wealth accumulation — and why low savings rates are so damaging over long horizons.
Compounding frequency matters
Interest can compound annually, quarterly, monthly, or daily. More frequent compounding produces slightly higher effective returns. A 6% annual rate compounded monthly has an effective annual rate of 6.17%. On small amounts, this difference is negligible. Over large sums or very long periods, it compounds into meaningful additional wealth. When comparing savings accounts, always look at the AER (Annual Equivalent Rate) rather than the nominal rate — AER accounts for compounding frequency.
The dark side: compound interest on debt
The same mathematics that builds wealth from savings destroys it with debt. A £5,000 credit card balance at 20% APR, if only minimum payments are made, can take over 20 years to clear and cost more than £10,000 in total interest. Student loans, car finance, and buy-now-pay-later schemes all use compound interest against the borrower. Understanding this is why financial advisers consistently prioritise paying off high-interest debt before investing — the guaranteed return of eliminating 20% debt beats most investment returns.
"Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it." — Attributed to Albert Einstein
What this means for you
Start early. A 25-year-old who invests £200 per month at 7% until age 65 accumulates approximately £525,000. A 35-year-old doing the same accumulates only £243,000 — less than half, despite only 10 fewer years. The lost decade of compounding in your 20s costs more than the contributions from your 30s, 40s, and early 50s combined. Time in the market, not timing the market, is the single most important variable in long-run wealth building.