How does compound interest differ from simple interest?

• A. Compound interest is calculated on both the initial principal and the accumulated interest from previous periods, while simple interest is calculated only on the initial principal.
• B. Compound interest is calculated only at the end of the investment period, while simple interest is calculated periodically.
• C. Simple interest increases exponentially over time, while compound interest increases linearly.
• D. Simple interest requires interest to be reinvested, while compound interest does not.

Answer: (A)

Verified step by step guidance

1. Understand the concept of simple interest: Simple interest is calculated only on the initial principal amount, and it does not take into account any interest that has been accumulated over previous periods.
2. Understand the concept of compound interest: Compound interest is calculated on both the initial principal and the accumulated interest from previous periods, meaning the interest is reinvested and grows over time.
3. Compare the calculation frequency: Simple interest is typically calculated periodically (e.g., annually, monthly), while compound interest involves reinvesting the interest and is calculated at the end of each compounding period.
4. Analyze the growth pattern: Simple interest grows linearly over time because it is based solely on the principal amount, whereas compound interest grows exponentially due to the reinvestment of accumulated interest.
5. Clarify misconceptions: Compound interest does not require interest to be reinvested manually; it is inherently reinvested as part of the calculation process, while simple interest does not involve reinvestment unless explicitly done by the investor.