We know that current savings interest rates are small and if the interest was compounded the extra financial gain might not be large, but nevertheless anything extra we can gain is helpful!
To consider the advantage of having interest compounded, we need to understand what this means. If you have savings or an ISA for a year, what you will gain at the end of the year is a return on the amount determined by the interest rate. For example, on £1,000 at 2% you would gain at the end of the year, as Simple Interest an additional £20 – taxable, or tax-exempt if in a Cash ISA. If however you decide to go for a longer-period investment – say a five year fixed term deal, because the interest rate (AER) offered is slightly better, will the longer term investment just give you a slightly better ’Simple Interest’ rate because your money is ‘locked in’ or could Compound Interest also come into play?
Over five years at 2.5% pa., your £1,000 with Simple Interest would earn £25 each year and after five years the total pot would be £1,125, however if Compound Interest was applied you would also receive ‘interest on the interest’ annually. Now at 2.5%, in the second year the compounded interest would be on £1000 + £25, adding 62.5p to the total interest, and after five years your total would be £1127.54. Now you may say that’s such a paltry sum it’s not worth the hassle of checking to see if Compound Interest is being applied. But remember, that’s the amount on an investment of only £1,000 for five years and clearly for larger savings amounts the compounded interest is greater and over longer periods can contribute to cushioning your savings pot against the effects of inflation.
The perception from savers who look closely at the situation on the high street is that most banks and building societies are now no longer paying compound interest on savings, losing savers a significant amount when they are locked into long period fixed term arrangements. It has also been commented that customers are rarely made aware of the situation on individual accounts. Currently, with low savings interest rates, it can be a struggle to ‘grow your nest egg’ and accounts that offer Compound Interest may just give you that bit extra!
