What is compound interest?

Compound interest is defined as interest that is calculated on the initial principal amount as well as on the accumulated interest from previous periods. This means that each time interest is calculated, it is done on a progressively larger base amount because it incorporates all prior interest earnings. This characteristic of compound interest allows for exponential growth of your investment or savings over time, especially when compounded frequently (annually, monthly, daily, etc.).

For example, if you invest $1,000 at an interest rate of 5% compounded annually, after the first year, you earn $50 in interest. In the second year, the interest is calculated on $1,050 (the original principal plus the first year's interest), resulting in $52.50. This process continues, leading to greater earnings over time compared to simple interest, which only calculates interest on the initial principal. Thus, the answer highlighting compound interest captures this essential aspect of how it works in financial contexts.