How does compounding interest work?

Compounding interest is a process where the interest earned on an investment is added to the principal amount, which then allows for more interest to be earned on the new total. In this context, the correct response indicates that interest is accumulated based on the total account balance. This means that not only is the original principal amount earning interest, but any interest that has been added to the principal also earns interest in subsequent periods. This mechanism is crucial because it allows savings or investments to grow at an accelerated rate over time, leading to more substantial financial growth compared to simple interest, which only applies to the initial principal.

Understanding how compounding interest works is fundamental in personal finance and investing, as it highlights the importance of time in the investment process; the longer the investment is allowed to compound, the more significant the growth will be. Investors often aim to take advantage of this effect by starting to invest early and allowing their money to grow through compounding.