What is compound interest?

Compound interest refers to the process of calculating interest not just on the initial principal amount but also on the interest that has been added to it over time. This means that as interest is earned, it is added to the principal balance, resulting in a higher amount of interest being calculated in future periods. This "interest on interest" effect can lead to substantial growth in savings or investments over time, particularly when compounded regularly.

For instance, if you invest $1,000 at an annual interest rate of 5% compounded annually, after one year, you'd earn $50 in interest. In the second year, interest is calculated on the new total of $1,050, which would yield $52.50 in interest, reflecting the impact of compounding.

Understanding the concept of compound interest is crucial for effective personal finance management, as it emphasizes the importance of starting to save or invest early and allowing time for growth through compounding effects. This concept is often highlighted in discussions about savings accounts, investments, and retirement planning, where maximizing returns through compound interest can significantly enhance wealth accumulation over time.