Top of main content

Compound interest explained

Compound interest is simply the interest you earn on the interest you've already received.

While that might sound a bit confusing, it’s fairly simple once you understand the concept. And it can make a big difference to the value of your savings over long periods of time, so it’s worth knowing about.

In this article, we'll guide you through:

What is compound interest?

How to take advantage of compound interest

How compounding works with investments

How compound interest affects borrowing

The pros and cons of compound interest

What is compound interest?

When you put money into a savings account, you can earn interest on your balance.

Interest rates are shown as a percentage, often called the AER (Annual Equivalent Rate).

To work out how much interest you’ll earn, you can multiply the amount you have saved by your interest rate, displayed as a decimal, where 100% is 1.

Here’s an example:

  • You have AED 1,000 in a savings account
  • The interest rate is 1.5% AER
  • 1,000 x 0.015 = 15
  • You’d earn AED 15 in the first year

If you left that money in your savings account – even without adding any more to it – you’ll be earning interest on a greater amount (AED 1,015) the next year. This is compound interest, and it can have a snowball effect on your savings.

Look at how your savings can grow over time:

Compound interest example

Year Starting balance Yearly interest earned at 1.5% AER Closing balance
1 AED 1,000 AED 15.10 AED 1,015.10
2 AED 1,015.10 AED 15.33 AED 1,030.44
3 AED 1,030.44 AED 15.56 AED 1,046.00
4 AED 1,046.00 AED 15.80 AED 1,061.80
5 AED 1,061.80 AED 16.04 AED 1,077.84
10 AED 1,144.44 AED 17.29 AED 1,161.73

Compound interest example

Year 1 1
Starting balance AED 1,000 AED 1,000
Yearly interest earned at 1.5% AER AED 15.10 AED 15.10
Closing balance AED 1,015.10 AED 1,015.10
Year 2 2
Starting balance AED 1,015.10 AED 1,015.10
Yearly interest earned at 1.5% AER AED 15.33 AED 15.33
Closing balance AED 1,030.44 AED 1,030.44
Year 3 3
Starting balance AED 1,030.44 AED 1,030.44
Yearly interest earned at 1.5% AER AED 15.56 AED 15.56
Closing balance AED 1,046.00 AED 1,046.00
Year 4 4
Starting balance AED 1,046.00 AED 1,046.00
Yearly interest earned at 1.5% AER AED 15.80 AED 15.80
Closing balance AED 1,061.80 AED 1,061.80
Year 5 5
Starting balance AED 1,061.80 AED 1,061.80
Yearly interest earned at 1.5% AER AED 16.04 AED 16.04
Closing balance AED 1,077.84 AED 1,077.84
Year 10 10
Starting balance AED 1,144.44 AED 1,144.44
Yearly interest earned at 1.5% AER AED 17.29 AED 17.29
Closing balance AED 1,161.73 AED 1,161.73

Notice that the amount of interest you earn each year increases. This happens even though the interest rate stays the same and you haven't added any more money.

The changes may seem small at first, but they grow exponentially. Compound interest has a greater effect the longer you save for and the larger the amount you start with.

How to take advantage of compound interest

The key thing to remember is that the earlier you start saving, the more time your money has to grow.

Even if you’re only putting away a small amount at first, it will start earning interest for future years.

If you can, it’s also a good idea to add money regularly to your savings account to keep your money growing.

Here’s another example of how your savings can grow, based on adding AED 500 per month to your initial AED 3,000 deposit with the same interest rate.

Compound interest example

Year Starting balance Total yearly contribution Yearly interest earned at 1.5% AER Closing balance
1 AED
3,000		 AED
6,000		 AED 
94.28		 AED 9,094.28
2 AED
9,094.28		 AED
6,000

 AED 
280.61		 AED 15,280.61
3 AED 15,280.61 AED
6,000

 AED 
560.38		 AED 21,560.38
4 AED 21,560.38 AED
6,000

 AED 
934.99		 AED 27,934.99
5 AED 27,934.99 AED
6,000

 AED 
1,405.89		 AED 34,405.89
10 AED 61,281.66 AED
6,000
 AED 
5,256.21		 AED 68,256.21

Compound interest example

Year 1 1
Starting balance AED
3,000 		AED
3,000
Total yearly contribution AED
6,000 		AED
6,000
Yearly interest earned at 1.5% AER AED 
94.28 		AED 
94.28
Closing balance AED 9,094.28 AED 9,094.28
Year 2 2
Starting balance AED
9,094.28 		AED
9,094.28
Total yearly contribution AED
6,000

 AED
6,000
Yearly interest earned at 1.5% AER AED 
280.61 		AED 
280.61
Closing balance AED 15,280.61 AED 15,280.61
Year 3 3
Starting balance AED 15,280.61 AED 15,280.61
Total yearly contribution AED
6,000

 AED
6,000
Yearly interest earned at 1.5% AER AED 
560.38 		AED 
560.38
Closing balance AED 21,560.38 AED 21,560.38
Year 4 4
Starting balance AED 21,560.38 AED 21,560.38
Total yearly contribution AED
6,000

 AED
6,000
Yearly interest earned at 1.5% AER AED 
934.99 		AED 
934.99
Closing balance AED 27,934.99 AED 27,934.99
Year 5 5
Starting balance AED 27,934.99 AED 27,934.99
Total yearly contribution AED
6,000

 AED
6,000
Yearly interest earned at 1.5% AER AED 
1,405.89 		AED 
1,405.89
Closing balance AED 34,405.89 AED 34,405.89
Year 10 10
Starting balance AED 61,281.66 AED 61,281.66
Total yearly contribution AED
6,000
 AED
6,000
Yearly interest earned at 1.5% AER AED 
5,256.21 		AED 
5,256.21
Closing balance AED 68,256.21 AED 68,256.21

As you can see, by year 10, you are earning over AED 5,000 just from interest. You will then earn interest on that amount in the years to come.

How compounding works with investments

When saving, it's also wise to think about inflation. 

Inflation is the rise in prices of everything from bananas to property. It means your money doesn't go as far as it used to. For example, AED 10,000 could buy you a lot more 30 years ago than it can today.

If the inflation rate is higher than your savings interest rate, the value of your money is actually decreasing each year. If you’re worried about this, you might consider investing.

Returns from investing can also compound over time, just like a savings account. However, the potential for growth is often much higher.

Remember that the value of investments can go down as well as up, so you could get back less than you put in.

Explore: New to investing?

How compound interest affects borrowing

Compound interest doesn't just work on savings. It also applies to money you borrow through loans or credit cards. 

This means you will pay interest on the interest you’ve already built up. That’s why you should try to pay off interest-bearing debt as soon as you can.

Explore: Managing your debt

Pros and cons of compound interest

Pros:

  • Faster growth: Your savings can grow more quickly over time
  • Rewards early saving: Starting early, even with small amounts, can lead to large gains
  • Boosts contributions: Adding money regularly helps amplify the compounding effect

Cons:

  • Inflation risk: Your savings could lose value if the interest rate is lower than inflation
  • Borrowing costs: It can make debts like loans and credit cards more expensive
  • Requires patience: The biggest benefits are seen over long periods, which may not suit short-term goals

Key takeaway

Compound interest is a powerful tool that rewards patience and regular saving. Starting early allows you to maximise its benefits and grow your savings.

However, it can work against you with debt, leading you to pay more over time. It's also important to consider how inflation affects your savings, which might make investing another option to explore.

Open a Savings Account

Our Savings Account is a great way to get into the savings habit.

Back to top  

What next?

Explore more

Discover our 6 tips to spend less and save money for your future.
Discover our 10 money saving challenges to help you save more.
Learn about the best ways to save for your retirement.

Disclaimer

The information provided above is for general information purposes only and does not constitute legal or financial advice. HSBC Middle East makes no representation or warranty as to the accuracy or completeness of the information. You should not rely solely on this material when making a financial decision. If you have any questions or wish to discuss your specific circumstances, please reach out to us.