What does 'compound interest' refer to?

Compound interest refers to the interest earned on both the initial principal amount and any interest that has already been added to that principal. This means that instead of merely earning interest on the original amount deposited or invested (the principal), you also earn interest on the interest that accumulates over time. This process allows for growth to occur at an accelerating rate due to the "interest on interest" effect.

For example, if you invest $1,000 at an annual interest rate of 5%, after the first year, you would earn $50 in interest. In the second year, you would earn interest not only on the initial $1,000 but also on the $50 interest that has already been added, leading to a total earning that compounds over time, significantly increasing the overall returns.

In contrast, other options detail concepts related to simple interest or specific conditions where interest is not compounded, which do not encapsulate the idea behind compound interest. Understanding this principle is fundamental in financial planning and investment management, as it demonstrates how investments can grow exponentially over time when interest is compounded.