How is compound interest calculated?

How is compound interest calculated?

• A. Applied solely to the initial principal amount
• B. Based on previous principal amounts plus unpaid interest
• C. As a flat percentage irrespective of outstanding balance
• D. Only calculated at loan maturity

Answer: (B)

Compound interest is calculated based on previous principal amounts plus any unpaid interest. This means that the interest for a specific period is added to the principal, and then the next interest calculation is performed on the new total. This process allows the investment or loan balance to grow at an increasing rate over time, as interest is earned on both the original principal and the accumulated interest from prior periods. This method contrasts with simple interest, which is calculated only on the initial principal amount without taking into account the interest that has previously accrued. In this way, compound interest can lead to exponential growth of an investment, making it a powerful tool in finance and saving strategies. Understanding how compound interest works is crucial for planning financial investments, loans, and savings, as it significantly impacts the total amount paid or earned over time.

Compound interest is calculated based on previous principal amounts plus any unpaid interest. This means that the interest for a specific period is added to the principal, and then the next interest calculation is performed on the new total. This process allows the investment or loan balance to grow at an increasing rate over time, as interest is earned on both the original principal and the accumulated interest from prior periods.

This method contrasts with simple interest, which is calculated only on the initial principal amount without taking into account the interest that has previously accrued. In this way, compound interest can lead to exponential growth of an investment, making it a powerful tool in finance and saving strategies.

Understanding how compound interest works is crucial for planning financial investments, loans, and savings, as it significantly impacts the total amount paid or earned over time.