Compound interest is the return on principal
1) only.
2) for one or more periods.
3) for two or more periods.
4) for one period.
The correct answer and explanation is:
The correct answer is: 2) for one or more periods.
Compound interest refers to the interest that is calculated not only on the initial principal amount but also on the interest that has already been added to it from previous periods. In other words, compound interest grows the investment exponentially because each period’s interest is calculated on an increasingly larger principal. This is different from simple interest, which only calculates interest on the original principal amount, regardless of how much interest has already been added.
For compound interest to be applied, it must span at least one period. The longer the investment is held, the more significant the effect of compound interest becomes. Over multiple periods, the interest earned in one period becomes part of the principal for the next, which results in interest being earned on interest.
In a typical example, suppose you invest $100 at an annual interest rate of 5%. After the first year, the interest earned would be $5, so the total amount is $105. In the second year, the interest would be calculated on the new total of $105, and not just on the initial $100. This is the key characteristic of compound interest—interest earned is reinvested, and it leads to a snowball effect over time.
For compound interest to be truly effective, it needs to occur over multiple periods. Even if the interest is compounded annually, the principle of earning interest on interest means the returns will be higher over time. The more frequently the interest is compounded (e.g., monthly or daily), the greater the effect over the same period.
In summary, compound interest applies to an investment for one or more periods and grows over time as it includes interest on both the initial principal and accumulated interest.