What is compounding interest?

Compounding interest refers to the process by which interest is calculated not only on the initial principal amount of a loan or investment but also on the interest that has been added to the principal over time. This means that the total amount of interest earned or owed grows exponentially, as future interest calculations include both the original principal and any interest that has already been added.

This concept is crucial in personal finance because it can significantly increase the value of investments over time. When interest is compounded, it can lead to a larger accumulation of wealth or higher repayment amounts on a loan, depending on the context. The effect of compounding can be seen over longer periods, making it a powerful tool for growing savings or investments.

The other options refer to different types of interest calculations. Interest calculated only on the principal does not take into account the accumulated interest, thus is not compounding. Similarly, while simple interest is a method of calculating interest, it does not account for previously accrued interest in its calculations. Compounding interest specifically encapsulates the idea of earning "interest on interest," which is why the correct choice is the one that emphasizes both the principal and accumulated interest.