What is compound interest?

• A. Interest paid only on the original principal
• B. Interest calculated on the principal and accumulated interest
• C. A fee charged for early withdrawal of savings
• D. Interest that does not accrue over time

Answer: (B)

The concept of compound interest refers to the process by which interest is calculated not only on the original principal amount invested or borrowed but also on the interest that has already been added to that principal. This means that with compound interest, over time, you earn interest on your initial investment as well as any interest that has already been added to it. This leads to exponential growth of the investment or debt, as the amount of interest earned increases with each compounding period.

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, interest is applied not just to the original $1,000, but also to the $50 earned in the first year, resulting in a total of $1,050 earning interest, and so on. This compounding effect can substantially increase the total return on investments over time, making it a powerful tool for savings and investing.

The other choices highlight concepts that are distinct from compound interest. Interest paid only on the original principal refers to simple interest, which does not have the compounding factor. A fee charged for early withdrawal of savings relates to penalties on certain accounts rather than how interest accrues.