What is compound interest?

Compound interest refers to the process where interest is calculated on the initial principal amount as well as on the accumulated interest from previous periods. This means that, over time, the interest earned not only adds to your balance but also earns additional interest in the future. This results in a snowball effect where the balance grows at an increasing rate, making compound interest a powerful tool for saving and investing.

This concept is crucial for understanding how savings accounts, investments, and loans can grow or increase over time, ultimately leading to higher returns compared to simple interest, which is calculated only on the principal amount. By recognizing the impact of compounding, individuals can make more informed decisions regarding their personal finances, highlighting the importance of time in the investment process.

The other options clarify different aspects of interest calculation. Interest calculated only on the principal does not consider the additional earnings from prior interest, and interest that does not consider previous periods also refers to a simplistic approach where only the initial amount is used for calculations. A fixed interest rate on loans indicates a stable rate but does not provide a definition for compound interest itself. This reinforces the significance of understanding the nature of compound interest and its benefits in finance.