Simple interest and compound interest both describe how money grows over time, but they work in fundamentally different ways. Simple interest is calculated only on the original principal. Compound interest is calculated on the principal plus all previously earned interest. Over long periods, the difference is substantial — and almost every UK savings account, ISA and investment account uses compound interest.
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The key difference — £10,000 at 5% over 20 yearsSimple interest: £10,000 + (£500 × 20) = £20,000Compound interest (annual): £26,533Compound interest (monthly): £27,126Difference (compound monthly vs simple): £7,126
How simple interest works
Simple interest is calculated using the formula: Interest = Principal × Rate × Time
On £10,000 at 5% per year for 10 years: £10,000 × 0.05 × 10 = £5,000 interest. Total: £15,000.
Simple interest is rarely used for savings accounts in the UK. It appears most commonly in short-term loans, some personal loan agreements, and as a simplified illustration in financial education. The important point: with simple interest, you earn the same £500 per year regardless of how long you have been saving, because the interest never adds to the balance that earns future interest.
How compound interest works
Compound interest is calculated on the full balance, including previously earned interest. The formula is: A = P(1 + r/n)^(nt)
On £10,000 at 5% AER compounding monthly for 10 years: A = £10,000 × (1 + 0.05/12)^(12×10) = £16,470
In year one, you earn approximately £512 in interest (slightly more than the simple interest £500 because monthly compounding adds interest to interest within the year). In year two, you earn interest on £10,512 rather than £10,000. By year 10, you are earning approximately £783 in interest in a single year — 56% more than the original year despite the rate never changing.
Side-by-side comparison — £10,000 at 5%
| Year | Simple interest balance | Compound interest balance (monthly) | Advantage of compounding |
|---|---|---|---|
| 1 | £10,500 | £10,512 | £12 |
| 5 | £12,500 | £12,834 | £334 |
| 10 | £15,000 | £16,470 | £1,470 |
| 20 | £20,000 | £27,126 | £7,126 |
| 30 | £25,000 | £44,677 | £19,677 |
| 40 | £30,000 | £73,584 | £43,584 |
The compounding advantage is small in early years and accelerating in later years. This is why time in the market matters so much — the powerful effect of compounding only becomes visible after a decade or more.
Compounding frequency — daily vs monthly vs annual
Most UK savings accounts compound monthly. Some compound daily. The difference between monthly and daily compounding at the same nominal rate is small but worth understanding:
| Compounding frequency | £10,000 at 5% after 20 years |
|---|---|
| Annual | £26,533 |
| Quarterly | £26,851 |
| Monthly | £27,126 |
| Daily | £27,183 |
| Continuous | £27,183 |
The AER (Annual Equivalent Rate) standardises these differences, which is why comparing accounts by AER rather than gross rate gives you the true comparison. An account paying 4.89% gross compounding monthly has an AER of exactly 5.00%.
Which UK accounts use compound interest?
| Account type | Interest type | Compounding frequency |
|---|---|---|
| Easy-access savings account | Compound | Monthly or daily |
| Fixed-rate bond | Compound | Annual or monthly |
| Cash ISA | Compound | Monthly |
| Stocks and shares ISA | Compound (reinvested returns) | Continuous |
| SIPP / pension | Compound (reinvested returns) | Continuous |
| Premium Bonds | Neither — prize-based | Monthly draw |
| Current account | Simple (where interest paid) | Annual (rare) |
Find a regulated IFA to advise on the right savings structure in the Kaeltripton Financial Index.
This article is for informational purposes only and does not constitute financial advice. All figures are illustrative examples calculated using standard compound interest formulas.
Frequently asked questions
Do UK savings accounts use compound or simple interest?
Almost all UK savings accounts, ISAs and investment accounts use compound interest. Interest is typically added to your balance monthly or daily, and future interest is then calculated on that higher balance. The AER (Annual Equivalent Rate) quoted on UK savings products reflects the effect of compounding over a full year.
Is compound interest always better than simple interest?
For savings, yes — compound interest always produces a higher return than simple interest at the same rate over the same period, because you earn interest on your interest. For borrowing, compound interest means debt grows faster than simple interest — which is why credit card balances can escalate quickly if not paid off.
What is the difference between AER and gross rate?
The gross rate is the stated annual interest rate before compounding. The AER (Annual Equivalent Rate) shows what you actually earn over a year once compounding is applied. For monthly compounding, the AER is slightly higher than the gross rate. A gross rate of 4.89% compounding monthly equals an AER of 5.00%. Always compare savings accounts using AER.
Sources and verification
- All compound interest figures calculated using A = P(1 + r/n)^(nt)
- FCA — AER definition and disclosure requirements for UK savings products
- Moneyfacts — UK savings account compounding frequency survey, April 2026
