Which of the following best defines compound interest?

• A. Interest calculated on both the initial principal and the accumulated interest from previous periods.
• B. The process of repaying a loan through equal periodic payments over time.
• C. Interest calculated only on the initial principal for each period.
• D. The present value of a future sum of money discounted at a specific rate.

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of compound interest. Compound interest is the interest calculated on the initial principal and also on the accumulated interest from previous periods. This contrasts with simple interest, which is calculated only on the initial principal.
2. Step 2: Review the options provided in the problem. The correct definition of compound interest should align with the idea of interest being calculated on both the principal and the accumulated interest.
3. Step 3: Eliminate incorrect options. For example, 'Interest calculated only on the initial principal for each period' describes simple interest, not compound interest. Similarly, 'The process of repaying a loan through equal periodic payments over time' refers to amortization, not compound interest. Lastly, 'The present value of a future sum of money discounted at a specific rate' relates to the concept of present value, not compound interest.
4. Step 4: Identify the correct option. The definition that matches compound interest is: 'Interest calculated on both the initial principal and the accumulated interest from previous periods.'
5. Step 5: Reflect on the importance of compound interest in financial accounting. Compound interest is a key concept in finance, as it demonstrates how investments grow over time due to the reinvestment of interest earned.