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The power of compound interest

Posted on 20 Aug 2014 by Mat Gazeley

Anyone who is serious about their finances and looking to maximise their returns should get clued up about compound interest. Although compound interest is a relatively simple concept, it can be an incredibly powerful force for growing your money. Given enough time, even a modest investment can grow significantly when the returns are compounded.

Einstein was a huge fan and even referred to compound interest as the eighth wonder of the world.

How it works?

The basic principle of compound interest is the ability to earn additional interest on interest already earned. As you receive each interest payment, it can be reinvested alongside the initial investment, meaning your funds have the potential to grow exponentially.

This is one of the key benefits of peer-to-peer lending especially when compared to some savings bonds which pay interest in lump sums at the end of the term. With Zopa as your interest can be relent monthly you can earn even more interest, making your money work even harder.

Here comes the math

As an example, let’s say you invest £10,000 for 15 years at an annual interest rate of 5.2% through Zopa - you could double your initial investment to over £21,000 returning you more than £11,000 in interest. That is more than the initial principle invested. Powerful stuff!

Obviously, in the real world of peer-to-peer lending, such returns are not guaranteed as rates can go up as well as down, and your capital is at risk. That said, by compounding your interest you can dramatically increase your future returns. There is potential for these to be even greater by adding regular monthly amounts to the investment process. Even small amounts like £100 a month can make a significant difference.

However, when hoping to benefit from compound interest investors should keep an eye on inflation as it has the potential to eat away at your interest. Therefore it’s important to try and achieve a return that is higher than the rate of inflation, currently at 1.6%. This is where currently many high street banks fall flat, because the interest rates they pay are often well below inflation.

As Giles our CEO and co-founder, points out: “Compound interest is an incredibly powerful way to grow an initial investment, and the longer the money is invested or relent the bigger the compounding effect. While some lenders will prefer a regular income stream, for those wondering whether compound interest is the right strategy for them, it’s hard to argue with Albert Einstein as he famously said, ‘He who understands it, earns it… he who doesn’t pays it’.”

To see how compound interest could earn you greater returns on your money, have a play with Zopa’s interest calculator.

Category: Lending

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