Managing finance: Video playlist

What is compound interest?

Compound interest means you earn interest not only on your original money, but also on the interest that has already been added.

Sophie has put £2,000 into a savings account. The £2,000 receives 3% interest per year over four years.

After one year, the bank calculates 3% of the principal amount of £2,000. 3% of £2,000 is £60. So at the end of the first year, Sophie would have £2,060.

In the second year, the bank calculates 3% on the new total: £2,060.

First, divide £2,060 by 100 to get 1%. Multiply by three to get £61.80. £2,060 add £61.80 equals £2,121.80.

Notice that in the second year, she earned more interest than in the first year.

Credit cards and loans also use compound interest. Interest is added based on what you owe, which means you may end up paying far more than you originally borrowed.