What is the process of earning interest on interest called?

The process of earning interest on interest is called compounding interest. This occurs when the interest that is earned on an investment or savings account becomes part of the principal amount, and subsequently, interest is calculated on this new total. This leads to exponential growth of the investment over time, as the interest continues to accumulate on an increasingly larger principal sum.

For example, if you have an account that earns 5% interest annually, and you earn $100 in interest during the first year, the second year will earn interest not only on your original investment but also on that $100 of interest, leading to a higher total for the second year's interest calculation. This effect can significantly enhance savings or investment returns over long periods, demonstrating the power of compounding.

Simple interest, in contrast, is calculated solely on the principal amount, while fixed interest maintains a set rate throughout the investment period. Variable interest changes periodically and can be more unpredictable than either simple or compound interest. Understanding compounding is crucial for effective financial management and investment strategies.