What is compound interest and why is it powerful for long-term investing?

• A. Reinvesting periodic interest results in lower overall returns.
• B. Earning interest on interest over time, leading to exponential growth of invested principal.
• C. Interest compounds only if you invest for at least 5 years.
• D. Compound interest means you can withdraw principal without any growth.

Answer: (B)

Compound interest means you earn interest not just on your original investment, but also on the interest that has already been added to your balance. Each period the interest is calculated on a larger amount, so the balance grows faster over time. This creates a snowball effect—the longer your money stays invested, the more gains build on top of gains.

For example, with 5% annual compounding, $100 grows to about $105 after the first year, about $127.63 after five years, and about $162.89 after ten years. The growth accelerates with time, which is why compounding is especially powerful for long-term investing.

So the best description is that you earn interest on interest over time, leading to exponential growth of the invested principal. Reinvesting interest does not reduce returns. Compounding can begin with any positive amount and any time period, not only after five years. And compound interest is about growth—not the idea of withdrawing principal without any growth.