Which of the following best defines compound interest?

• A. Interest based only on the initial principal.
• B. Interest calculated only on accumulated interest.
• C. Interest calculated on both the initial principal and accumulated interest.
• D. Interest that is not added to the principal.

Answer: (C)

Compound interest is best defined as interest that is calculated on both the initial principal and the accumulated interest from previous periods. This means that each time interest is calculated, it builds upon not just the original amount invested or borrowed, but also on any interest that has already been earned or applied in past periods. Therefore, the total balance grows at a faster rate over time compared to simple interest, which is calculated solely on the initial principal without taking into account any previously accrued interest.

For example, if you invest money in a savings account with compound interest, the interest earned in the first year is added to the principal. In the second year, interest is calculated on this new total, which includes the original principal plus the interest earned in the first year. This characteristic of compounding makes it a powerful tool for growing investments over time.