What is compound interest?

Compound interest is defined as the interest calculated on both the principal amount and any accumulated interest that has been added to it. This means that, over time, the interest can earn interest itself, leading to exponential growth of the investment or loan.

This concept is significant in financial decision-making because it illustrates how investments can grow significantly over time when interest is calculated on both the original amount and the interest that accumulates. For instance, if you invest $1,000 at a compound interest rate, not only do you earn interest on that initial amount, but you also earn interest on the interest that has been added in previous periods.

This understanding is crucial for analyzing savings accounts, loans, and other financial products that involve interest calculations. In contrast to simple interest, which only accounts for the principal amount, compound interest demonstrates the potential for greater increases in value over time.