Demystifying compound interest: how it works and how you can benefit

Compound interest is a term commonly used in the banking industry when talking about interest rates, savings and investments. But what does compound interest mean? On this page, you’ll learn what compound interest means for Irish savers, how compound interest works, what compounding periods are and understand the benefits of opening savings accounts with compound interest.

Compound interest is the interest you earn from your original deposit combined with the interest you’ve earned so far. If you make deposits into a compound interest savings account where interest is paid annually, you’ll keep earning interest on each previous year’s interest. This means that if the rate of interest stays the same, you’ll earn more from your savings every year your interest compounds.

How does compound interest work?

Here’s a simplified example of how compound interest works:

If you deposit €2,000 into a savings account that offers a fixed interest rate of 10% and pays interest annually, you’ll earn €200 in interest on the first anniversary of opening your savings account, giving you a balance of €2,200.

If you don’t make any deposits or withdrawals during the second year, you’ll earn another 10% in interest, but this time, that 10% will be on a savings account balance of €2,200. 10% of €2,200 is €220, so that means you’ll earn €220 in interest, and your balance at the end of year two will be €2,420. You’ll have earned interest on your original deposit and also on the interest you earned in year one.

This is an overly simplified explanation of how compound interest works, as other factors affect how interest is calculated, paid and compounded, but this gives you an idea of the process. Compound interest means that the amount of interest paid on your savings will grow, even if you don’t make any more deposits. Of course, if you do make deposits, you’ll earn interest on those, too.

If the savings account you choose pays interest more than once a year, the compounding effect is greater as interest is paid more frequently. It’s always best to check how often interest is paid if you’re considering savings accounts that pay compound interest.