What is compound interest?

Compound interest is best described as interest calculated on both the initial principal and any accumulated interest from previous periods. This means that, over time, the interest grows on the total amount, which includes both the original investment and any interest that has been added to it. This results in the investment growing at an accelerating rate, as you earn interest on a progressively larger base.

For example, if you invest $1,000 at an annual interest rate of 5%, the interest for the first year is calculated on the $1,000. In the second year, the interest is calculated on $1,050, which includes the initial investment plus the interest earned in the first year. This compounding effect leads to higher returns over time compared to simple interest, which only calculates interest based on the principal amount over the entire investment period.

The other options reflect different concepts or misunderstandings regarding how interest accumulates, specifically focusing solely on the principal or not considering the growth of interest over time. Therefore, the correct understanding of compound interest aligns with its definition as the interest computed on the principal plus any interest that has been added from previous periods.