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It was revealed recently that you can become a millionaire by the time you retire just by saving £18 a week from the age of 22. And actually, it’s entirely true. Compound interest is being branded as ‘the intelligent way of saving’ and is making it’s prominence into the financial world as time goes on. But what is compound interest, and more importantly – how can you make use of it?

What Is Compound Interest?

Compound interest works by, effectively, paying interest on the interest you’ve already acquired through savings. For example, if you have £1,000 in a savings account earning 5% AER and interest is paid to you yearly, you’ll have £1,050 at the end of the year.

So, the next year, you’ll earn 5% on £1,050 – which means that at the end of year two your savings will now be worth £1,102.50. As opposed to the original £1,100 they would have been worth had you withdrew your interest initially.

This may not sound like much, but when ticking in the background over time – it soon mounts up. The more interest you earn each year, the more interest that is paid on that additional interest each year. The total interest value increases thanks to compound interest – and you don’t even have to do anything bar keep it there in your bank account and let it accumulate.

Some banks and building societies offer the option to ‘pay away’ your interest, meaning that when you accumulate it – it’s transferred to another account. However, to do this would mean that while you’re saving your interest earned – you’re also missing out on the chance to acquire even more cash on top of it.

To understand further what compound interest is, this 1-minute video is a great watch.

How To Work Out Compound Interest

Year  Opening Balance (P)   Interest 5 % (I)   Closing Balance (P+I)  
Year 1 £10,000.00 £500.00 £10,500.00
Year 2 £10,500.00 £525.00 £11,025.00
Year 3 £11,025.00 £551.25 £11,576.25
Total Interest      £1,576.25

How To Make The Best Use Out Of Compound Interest

To really benefit from compound interest, you’ll want a high-interest account. If you don’t currently have one, an ISA – in particular, a Lifetime ISA – would be great for this. These accounts pay you a good return on investment and you’re encouraged not to remove what you accumulate – which works hand in hand with compound interest.

The latest Lifetime ISA offers a massive 25% Government bonus. You have to be under 40 to open a Lifetime ISA but if you fall under the remit and are happy to keep your money working in the account until around the 60-year old mark, it can boost your savings through the roof. Up to £4,000 a year can be invested in a Lifetime ISA, giving a maximum Government bonus of £1,000.

Who Would Compound Interest Work Best For?

Generation Z And Millennials

Referring back to the aforementioned article, it has been deeply recommended that the younger generation starts intelligently saving now in order to create a comfortable future for themselves. It’s been predicted that if you start saving £18 a week at 22 years of age, and combine it with compound interest savings and government bonuses – you could well be a millionaire by the time you meet retirement age.

Savers, Not Spenders

It goes without saying, but for compound interest to work effectively – you need to be a frugal saver. It can be tempting to withdraw your interest as you earn it, especially if it’s a good amount. However, to keep on removing the interest you accumulate would mean that you can never earn more unless you keep filtering in your own money. If, on the other hand, you’re disciplined enough to leave your savings account alone for a number of years, you’ll soon find the interest racking up, leaving you with more to enjoy retirement with in the future.

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