What is compound interest?

Compound interest is defined as the interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods on a deposit or loan. This means that not only does the principal earn interest, but the interest that has been added to that principal also earns interest. This results in interest being calculated on a growing balance, which can significantly increase the amount of interest earned over time compared to simple interest, where interest is calculated solely on the principal.

Understanding this concept is crucial for effective financial planning and investment, as it highlights the benefits of savings and investments that grow over time. The compounding effect can lead to significant future value for investments, especially when they are allowed to grow over longer periods.

In contrast, the other choices refer to different financial concepts completely unrelated to compound interest. For instance, interest paid only on the principal amount describes simple interest. A general increase in prices refers to inflation. The total income received before deductions relates to gross income. These concepts are important in their own right but do not accurately describe the nature of compound interest.