Jasmine Birtles
Your money-making expert. Financial journalist, TV and radio personality.
What is Compound Interest and How Does It Work?
George Sweeney
5th Nov 2025
If there’s one piece of financial wisdom everyone should know, it’s this: compound interest is the secret sauce of wealth-building.
It’s not glamorous. It’s not exciting. But it’s powerful. And once you understand how it works, you’ll see why smart investors let time (and compound interest) do the heavy lifting.
What is Compound Interest?
When you invest money, you earn interest on it (or at least, you should do!).
But here’s where the magic begins:
The next year, you earn interest on your original money and on the interest you made before.
Then the following year, you earn interest on that even bigger total… and so it goes on.
Each year your money grows faster. Not because you’re adding more, but because your interest is earning its own interest.
That’s compound interest in action, your money quietly working for you behind the scenes.
The ‘Chess Board’ Allegory
There’s a famous story that illustrates the extraordinary power of compound interest (once described by Albert Einstein as the 8th Wonder of the World).
It goes:
“Legend has it there was an Indian King who was obsessed with chess. The King held his own skills in rather high regard, and often bested the scholars in his realm in friendly matches.
“Whenever a new traveller entered his kingdom, he would challenge them to a game, and if they beat him, he would reward them with any treasure or prize they desired.
“One day a pilgrim wandered into his land and was challenged to a game by the King. What the King didn’t know is that our pilgrim friend was actually a chess grandmaster and had been playing his whole life. When asked his terms, he modestly requested: “Your Highness I would simply like a single grain of rice for the first square and then for each corresponding square to double the last”. The king laughed and agreed to these measly terms.
“The pilgrim went on to beat the king in impressive fashion and left the crowd gob-smacked. However, although stunned, the King stayed true to his promise and acknowledged that the pilgrim’s reward would be met.
“The King’s servants began placing grains of rice upon the chess board – one in the first square, two in the second, four in the third, eight in the fourth and so on.
“It didn’t take the King long to realise that he may have bitten off a little more than he could chew. He calculated that by the 30th square he would be required to put down 1 billion grains of rice, and by the 64th and final square he would need to reward the pilgrim with roughly 18,000,000,000,000,000,000 grains (that’s eighteen quintillion for those playing at home). That is about 210 billion tons of rice, the same as around 10.5 million sphinxes of Egypt – or enough to cover the whole of modern-day India in a one metre thick layer of rice.
“The pilgrim, being the kind and understanding individual that he was, acknowledged that it was a ridiculously large amount of rice and agreed that the king could pay it off annually, and even pay him in other assets like gold or land.”
How Does Compound Interest Work?
When you save and invest money, all being well, you’ll earn a rate of return on your investment.
The words ‘return’ and ‘interest’ are interchangeable. This is why you’ll sometimes see compounding called ‘compound returns’.
Both mean the same thing, just a tweak in the language.
So, imagine you invest £100.
And in a year, you get a 5% return. This will mean that you end up with £105 by the end of the twelve months.
In the following year, you reinvest that £105 for another 5% return. By the end of the second year, you’ll have £110.25, without you having to add in any extra money.
I’m not suggesting that a fiver will change your life.
But, when you start using larger sums and allowing more time for the money to compound, the growth results are pretty astonishing.
A simple example
Let’s make it real.
You invest £100 and earn 10% per year.
Here’s how your money would grow:
| Year | Starting Balance | 10% Interest | Total at Year End |
|---|---|---|---|
| 1 | £100.00 | £10.00 | £110.00 |
| 2 | £110.00 | £11.00 | £121.00 |
| 3 | £121.00 | £12.10 | £133.10 |
| 4 | £133.10 | £13.31 | £146.41 |
| 5 | £146.41 | £14.64 | £161.05 |
At the end of 5 years, your £100 has turned into £161.05- without you adding another penny.
That might not sound like much, but give it time and consistency, and the results can be extraordinary.
How Do You Calculate Compound Interest?
There’s a simple formula to work out how much your money could grow:
A = P (1 + r/n)ⁿᵗ
Where:
-
A = the final amount
-
P = the starting amount (your principal)
-
r = the annual interest rate (as a decimal)
-
n = the number of times the interest is added per year
-
t = the number of years
Example:
If you invest £1,000 at 5% interest, compounded annually for 10 years, you’d calculate:
A = 1000 × (1 + 0.05)¹⁰ = £1,628.89
That’s £628.89 earned without lifting a finger.
But for the most part, you don’t need to calculate things manually using the formula.
The easiest way to calculate compound interest is by using a calculator.
If you’ve never used a compound interest calculator before, you’re in for a treat.
They’re very easy to use and if the results don’t get you pumped about investing and growing your money, I don’t know what will.
Here’s a couple of online calculators you can have a play around with to see for yourself:
Why Compound Interest Is So Powerful
Two simple reasons make compounding a game-changer:
Small Differences Make a Big Impact
Even a tiny increase in your interest rate (or investment return) can make a huge difference over time.
Let’s say you invest £10,000 for 30 years:
- At 5%, it grows to £43,219
- At 7%, it grows to £76,123
That’s a £30,000 difference, just from a 2% higher return!
Time Is Your Best Friend
The earlier you start, the more time your money has to snowball.
Take this example:
If you invest £100 a month at 10% a year for 40 years, you’d end up with an incredible £559,461.
But if you waited 10 years to start, you’d only have £206,552.
That’s a £352,909 difference, all because of time!
The moral of the story?
Don’t wait for “the right time.” The right time to start investing is as soon as possible.
Can You Get Rich From Compound Interest?
You certainly can. The key ingredients to becoming rich with compound interest include:
- Time
- Steady and consistent returns
- Regular investing
- Low fees and costs
It’s worth pointing out – how much time you have and the return you generate may be out of your control.
Don’t fret if your time horizon is shorter, just make the most of the time you do have.
If you are younger and have time on your side, it’s so important to invest early. Because, small amounts over those extra years will pay off in the long run.
Choosing to invest regularly and opting for low fees is actually something you can control, so make sure you do.
Investing even just small amounts will be worth it. I know that there might be a big squeeze on your money right now, but anything you can manage will go a long way.
If you’re struggling to find a cheap brokerage account, eToro is a great option. It’s free to open an account and there are no fees for buying investments.
Just like your returns compound, so do your costs. Cheap is good, free is better.
If you need a hand with getting set up, we created this great guide explaining how to create an account and buy shares with eToro.
Using Compound Returns to Build Wealth
To show you just how powerful compound interest can be, here’s a rough example to give you an idea of the magic.
If you begin investing at 20 years old and invest £50 a month until you’re 60, with a 5% return each year, you’d end up with just over £100,000.
Now, if you changed it up and got a return of 9% (which is roughly the yearly return from the S&P 500 index), and you invested slightly more at £250 a month, you’d be left with £1,170,000 by the time you turn 60.
What’s incredible about this is that only £120,000 of that figure is from your monthly investments.
The remaining £1,050,000 is pure interest due to compounding!
However, if you’re not savvy with your accounts, this figure would be much lower if you have high costs or pay lots of tax on that growth.
The best way to (legally) to avoid paying tax on the growth of your investment portfolio is by making sure you make the most of your stocks and shares ISA.
You get a £20,000 allowance each year, which is plenty for most of us.
Keeping your investments in this tax wrapper protects the growth from dividend and capital gains tax. And, you don’t pay any income tax once you start withdrawing or living off your portfolio.
Investing To Benefit From Compounding Returns
How you choose to invest your money will be down to your own personal preferences and situation.
If you need some inspiration, we’ve got plenty of free information and guides here at MoneyMagpie. Including, how to find high dividend shares and ways to invest in the FTSE 100 index.
To learn more about investing, do sign up for our fortnightly MoneyMagpie Investing Newsletter.
Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.
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