What does compound interest refer to?

Compound interest refers to the method of calculating interest where the interest earned or charged is added to the principal amount. This means that over time, you not only earn interest on your original investment (the principal) but also on any interest that has been added to that principal in previous periods.

In this method, each compounding period (which could be annually, semi-annually, quarterly, monthly, etc.) effectively means that the total amount (principal plus accumulated interest) is used to calculate the next period's interest. As a result, the total amount grows at a faster rate than simple interest, which is calculated only on the initial principal.

The understanding of this concept is crucial for financial planning, as it can significantly affect investment growth and savings estimates over time. An investment utilizing compound interest has the potential to yield higher returns compared to those assessed with simple interest.