What is compound interest?

• A. Interest applied only to the principal amount
• B. Interest calculated based on previously earned interest and principal
• C. Fixed interest that does not change over time
• D. Interest charged on credit card balances only

Answer: (B)

Compound interest is defined as interest that is calculated based on both the principal amount and any interest that has previously been added to that principal. This means that as interest accumulates over time, the total amount of interest earned (or charged) grows at an increasing rate because interest is earned on both the initial principal and on the interest that has been added in previous periods.

This method of interest calculation differs from simple interest, which is only applied to the principal amount throughout the investment or loan period. It also varies from fixed interest, which remains constant over time, and from interest charged only on credit card balances, which is a specific application of interest and does not encompass the broader definition of compound interest.

Understanding compound interest is crucial for personal finance, as it significantly impacts savings growth and the cost of borrowing over time.