Simple and compound interest
With simple interest, you only earn interest on the money you put in. With compound interest, you also earn interest on the interest you've already earned. Most savings accounts work the second way.
Say you save £1,000 at 4% a year and leave it alone. After one year you have £1,040. In the second year, you earn 4% on £1,040, not just on £1,000, so you end up with £1,081.60.
With simple interest, you'd have £1,400 after 10 years. Compounding adds an extra £80.24.
The gap starts small but grows every year. Over decades, it can become the biggest part of your money. You can see this in our compound interest calculator.
AER and APR: the two rates you'll see
- AER (annual equivalent rate) is used for savings. It shows what you'd earn in a year, including compounding, so you can compare accounts fairly. Higher is better for you.
- APR (annual percentage rate) is used for borrowing. It includes interest and most fees, so you can compare the cost of loans and credit cards. Lower is better for you.
Why borrowing costs more
Lenders charge more interest than savings accounts pay. Credit cards and overdrafts often charge far more than you could earn by saving. That's why clearing expensive debt usually comes before saving extra. Building a safety net explains the order.
Interest and inflation
Inflation is how fast prices rise. If your savings earn 3% but prices rise by 4%, your balance grows, but it buys less than before. To keep up, your money needs to grow at least as fast as prices.
Is interest taxed?
Most people can earn some interest tax-free through the Personal Savings Allowance: £1,000 a year for basic-rate taxpayers, £500 for higher-rate taxpayers and nothing for additional-rate taxpayers. Interest inside an ISA is always tax-free.
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Go further
Ready for the practical side? Read Cash ISAs explained.
Sources
We checked this page against these sources on 9 October 2026. Rules and allowances can change, so always check the latest position on GOV.UK.
This page is general information, not personal financial advice. Read our full disclaimer.