What is compound interest?

Study for the GradReady Real-World Finance Exam. Utilize flashcards, multiple-choice questions, and detailed explanations to grasp essential financial concepts. Prepare for success!

Compound interest is defined as the interest that is earned not just on the original principal amount but also on any interest that has already been added to that principal. This means that as time goes on, interest is calculated on an increasingly larger balance, which leads to exponential growth of the investment or loan over time. The process of compounding allows investment gains to be reinvested, effectively earning additional interest, and this cycle can significantly increase the overall amount earned or owed.

In contrast, the other choices do not accurately represent the concept of compound interest. For instance, calculating interest only on the principal amount describes simple interest rather than compound interest. Additionally, saying interest compounds annually regardless of the investment overlooks the fact that compounding can occur at various intervals (e.g., monthly, daily). Finally, deducting interest from the investment refers to a cost or fee rather than a means of earning or accumulating interest. Thus, understanding that compound interest considers both the principal and previously accrued interest is crucial for grasping how investments can grow over time.

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