What is compound interest?

What is compound interest?

• A. Interest that is calculated only on the initial deposit
• B. Interest that is earned solely on previously earned interest
• C. Interest that is earned on both the initial deposit and previously earned interest
• D. Interest that is fixed for the life of the loan

Answer: (C)

Compound interest refers to the interest that is calculated not just on the initial principal amount of a deposit or investment, but also on any interest that has been added to that principal over time. This means that as the interest is added back into the account, it starts to earn interest itself in subsequent periods. This compounding effect can lead to significant growth in the total amount over time, especially when interest is compounded frequently, such as annually, semi-annually, quarterly, or monthly. In this context, the correct answer captures the essence of how compound interest works, emphasizing that it includes both the original sum and the interest that has accumulated from previous periods. By contrast, the other options either limit the calculation of interest to only the initial amount or suggest a fixed nature of interest that does not account for the benefits of compounding. This understanding is crucial for effective financial planning and investment strategy, as compound interest can dramatically influence the outcomes of savings and investment over time.

Compound interest refers to the interest that is calculated not just on the initial principal amount of a deposit or investment, but also on any interest that has been added to that principal over time. This means that as the interest is added back into the account, it starts to earn interest itself in subsequent periods. This compounding effect can lead to significant growth in the total amount over time, especially when interest is compounded frequently, such as annually, semi-annually, quarterly, or monthly.

In this context, the correct answer captures the essence of how compound interest works, emphasizing that it includes both the original sum and the interest that has accumulated from previous periods. By contrast, the other options either limit the calculation of interest to only the initial amount or suggest a fixed nature of interest that does not account for the benefits of compounding. This understanding is crucial for effective financial planning and investment strategy, as compound interest can dramatically influence the outcomes of savings and investment over time.