What is compound interest?

Compound interest is defined as the interest that is calculated not only on the initial principal amount but also on the interest that has previously been added to the principal. This means that as interest is earned on the account, it gets added to the principal, and future interest is then calculated on this new total. This process allows your investment or loan to grow at a faster rate compared to simple interest, which is calculated solely on the original principal.

The compounding effect can lead to significantly higher returns over time, particularly as the time period for investment increases. This concept highlights the power of reinvestment and is a fundamental principle in personal finance, as it impacts savings, loans, and investments directly. Understanding this mechanism is crucial for effective financial planning and maximizing potential returns.