Explain the term ‘compound interest.’

Compound interest refers to the method by which interest is calculated on the initial principal amount as well as on the accumulated interest from previous periods. This means that in each compounding period, the interest earned is added to the total balance, which then raises the amount on which future interest is calculated.

This process allows your investment or savings to grow at a faster rate than simple interest, which is calculated only on the initial principal. For example, if you earn interest in successive periods and that interest is reinvested, it will generate new interest in the next period, creating a snowball effect. The more frequently the interest is compounded, the more you can benefit from this rate of return, as the interest essentially earns interest over time.

Understanding compound interest is crucial in personal finance as it can significantly affect savings accounts, investments, and loan repayments. The longer the money remains invested or the longer the loan is taken out, the more powerful the effects of compound interest become.