What is compound interest?

Compound interest refers to the process of calculating interest not just on the initial principal amount, but also on the accumulated interest from previous periods. This means that as time passes, the total amount of interest increases because interest is earned on both the original investment and the interest that has already been added to that investment. This compounding effect can significantly increase the total value of an investment over time, especially when the interest is compounded frequently (e.g., annually, semi-annually, quarterly, etc.).

For instance, if you invest $1,000 at an interest rate of 5% compounded annually, in the first year, you earn $50 in interest (5% of $1,000). In the second year, you earn interest on $1,050 (the principal + the first year's interest), resulting in $52.50 in interest for that year. This cycle continues, demonstrating how compound interest can magnify returns over time.

The remaining options describe concepts that do not encapsulate the nature of compound interest. Some emphasize simpler calculations or an absence of growth, which diverges from the dynamic growth model that characterizes compound interest. Understanding compound interest is crucial for comprehending the benefits of long-term investing and savings strategies.