What is compound interest?

Compound interest is defined as interest that is calculated based on both the initial principal and the accumulated interest from previous periods. This means that not only is the interest earned on the original amount of money invested or borrowed, but it also includes interest earned on any interest that has previously been added to the principal. This compounding effect allows investments to grow at a faster rate over time compared to simple interest, which is only calculated on the principal amount.

For example, if you invest $1,000 at an interest rate of 5% compounded annually, in the first year, you earn $50 in interest. In the second year, interest is calculated on the new total of $1,050 (the original principal plus the first year's interest), resulting in $52.50 of interest for the second year. This pattern continues, ultimately leading to a more significant growth of the investment over time.

The other options do not accurately capture the essence of compound interest. Interest calculated only at the end of the investment period does not reflect how compound interest accrues over time. Interest applied only to the initial principal ignores the crucial aspect of accumulating interest that compound interest offers. Lastly, a fixed percentage of the principal that does not change describes a more static approach akin to