Future Business Leaders of America (FBLA) Personal Finance Practice Test

What does compounding refer to in the context of earnings on investments?

1. Interest earned on the principal only

2. Interest earned on both the principal and previously earned interest

3. Principal investment loss

4. Only earning fixed interest over time

The correct answer is: Interest earned on both the principal and previously earned interest

Compounding refers to the process where interest is earned not only on the initial principal amount of an investment but also on the interest that has been added to it over time. This means that as time goes on, the amount of interest earned can increase because each period's interest is calculated on a growing balance, which includes both the original principal and the accumulated interest from previous periods. For example, if you invest a sum and earn interest on that investment, during the next period, the interest calculation will include the previous interest earned, resulting in greater total earnings. This accumulation effect can significantly enhance the growth of an investment, especially over long periods and at higher interest rates. In contrast, the other options either focus solely on the original principal without accounting for generated interest or suggest scenarios that do not apply to the compounding process. Ultimately, understanding this principle is crucial for making informed investment decisions, as it highlights the importance of reinvesting earnings to maximize financial growth.