Which concept illustrates the principle of earning interest on previously earned interest?

The principle of earning interest on previously earned interest is best illustrated by compound interest. When you deposit money into an account that earns compound interest, not only does your initial investment, or principal amount, earn interest over time, but the interest that accumulates also begins to earn interest itself. This creates a compounding effect where your investment grows at an accelerated rate.

For example, if you invest $1,000 at a compound interest rate of 5% per year, you would earn $50 in interest after the first year. In the second year, you would earn interest on the new total of $1,050 (the original principal plus the interest earned), resulting in a higher interest amount for that year. Over time, this process significantly increases the total returns compared to simple interest, where interest is calculated solely on the principal without accounting for previously earned interest.

Understanding the concept of compound interest is crucial in personal finance, as it emphasizes the value of long-term investments and the benefits of reinvesting earnings to enhance growth.