Which term describes interest that compounds on both principal and previously earned interest?

• A. Simple Interest
• B. Compound Interest
• C. Dividends
• D. Capital Gains

Answer: (B)

Compound interest grows faster because it adds interest not only on the original amount you invested but also on the interest that has already been earned. Each period, the balance increases, so the next period’s interest is calculated on a bigger base. For example, $100 at 5% compound annually becomes $105 after one year, and $110.25 after two years (100 × 1.05^2). If it were simple interest, you’d only earn 5% of the original principal each year, giving $110 after two years (not compounding the new total). Dividends are payments from owning stock, and capital gains are increases in an asset’s price—neither describes interest earned on both principal and prior interest.