What's so interesting about interest? - A guide to compound interest

How I’m saving for my new daughter’s future- part 1: 

What is so interesting about interest?

A guide to Compound Interest


One of the most crucial concepts within finance is the area of interest. Compound Interest takes the money you start with and increases it exponentially over time. Understanding it helps with making good financial decisions, which benefit your long term future.

This is the first in a three part series explaining how I’m saving for my newborn daughter’s future. Let’s call her Gertrude. Gertrude was born in November and I want to make sure she has the best possible financial start. I'm going to let you in on the decision making process I used to do that. But there’s a little bit of ground work to do before jumping into what is happening with Gertrude’s money. The first two posts will give you that basic information before, and I know you’re excited, the third part will explain how I've used her money.

What is so interesting about interest?

Before we move to talk about the how and the why, there is some explaining to do about interest.

Depending on the interest rate on your savings the interest received will be higher or lower. So if you have £1,000 and invest it at 2% interest for one year, after the year you will have £1,020, with £20 of interest earned.

Now, the interesting thing happens in the second year. Assuming all of the initial amount, and the interest is left in, the £1,020 all earns 2% interest. You now have £1,040.40. So your interest in the second year is slightly higher than the first, 40p higher to be exact.

In the third year. The £1,040.40 earns £20.81. In the fourth year you earn £21.22p

This might not seem a lot, indeed it isn’t, but over time, this adds up. It’s called compound interest, and means that each year you earn more and more interest. Here’s a spreadsheet (7 blog posts done and this is the first spreadsheet, you’ve got to be happy with that!):

The spreadsheet shows 21 years. That’s the timeframe that the money will sit there until Gertrude accesses it.

As you can see, by the end of the 21 years, there is £1,516 in her bank account. £516 earned without doing anything. And now the annual interest is up to £30.31, a good bit higher than when we started.

But that’s still relatively small fry. Let’s take a look at the same spreadsheet for 7% or 10% interest.

Now this looks a little bit more interesting. Increasing the interest rates makes a huge difference to the amount at the end of the period. Without doing anything, at 7% the £1,000 becomes over £4,000 and at 10% it’s £7,400. Lovely jubbly.

That’s the thing, each year the interest keeps going up, leaving more and more in the account at the end of the year and increasing the interest in the account in following years.

Let’s add one more element to the calculation. What if you are able to add a bit to the account each year? Say £250. That’s just over £20 per month.

Here’s how we now look, using the 7% interest:

All of a sudden we are at £15,000, earning nearly £1,000 interest each year. That is not bad going. I’m very interested in that interest. If I could find somewhere that I could put £1,000 in and top it up by £250 per year to earn £15,000 by the time Gertrude is 21, that would be absolutely smashing.

The problem is, where to find a 7%+ interest rate at the moment? The best savings accounts are around 2-3%, much too low to see anything really interesting happening with the interest. That question will be answered over the course of the next two blog posts in this series.

Here's part 2: Risk vs Return- Probabilities and Peanut Butter

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