How is compound interest different from simple interest?

Compound interest differs from simple interest primarily in the way it is calculated and the impact it has over time. With compound interest, interest is not only calculated on the initial principal amount but also on any interest that has been added to this principal over previous periods. This means that as interest accumulates, the amount on which future interest is calculated increases, leading to a "snowball effect" where the total amount of interest earned grows faster over time.

This is particularly significant in long-term investments or savings, where the compounding frequency—such as annually, semi-annually, or monthly—can greatly affect the total returns. In contrast, simple interest is calculated solely on the principal amount, meaning the total interest earned remains constant over the period, leading to lower overall returns when compared to compound interest in the long run.

Understanding this difference is crucial for making informed decisions about savings and investments, as compound interest generally maximizes returns over time due to the effect of earning interest on interest.