Question 1

What is the difference between simple and compound interest?

Accepted Answer

Simple interest is always calculated on the original amount, so it grows in a straight line. Compound interest is calculated on the balance including interest already earned, so the growth accelerates. Over ten years at 5%, £10,000 becomes £15,000 with simple interest and about £16,470 with monthly compounding.

Question 2

Does compounding frequency matter much?

Accepted Answer

Less than people expect. At 5% over ten years, moving from yearly to monthly compounding adds about 1.6%, and monthly to daily adds a further 0.1%. The rate and the time matter far more than the frequency.

Question 3

How should I account for inflation?

Accepted Answer

Subtract the inflation rate from your interest rate to get a real return. A 4% account with 3% inflation is really growing at about 1% a year in purchasing power.