How is compound interest best described?

Compound interest is best described as interest paid on interest previously earned. This means that in addition to earning interest on the initial principal amount, interest is also calculated on any interest that has already been added to the account. Over time, this can lead to exponential growth of the investment or savings, as the base on which interest is calculated continually increases. This characteristic distinguishes compound interest from simple interest, which is only calculated on the principal amount.

The concept of compound interest is fundamental in finance, especially when considering savings accounts, investments, and loans, as it reflects how an amount can grow more significantly over time compared to simple interest, which would limit interest calculations to the original principal only.

Understanding this principle is crucial for making informed financial decisions, as it highlights the benefits of long-term saving and investing, where the compounding effect can substantially increase total returns.