How does compound interest differ from simple interest?

• A. Compound interest earns interest only on the initial principal amount.
• B. Simple interest earns interest on both principal and accumulated interest.
• C. Compound interest earns interest on previously earned interest, while simple interest is earned only on the principal amount.
• D. Both types earn interest at the same rate over time.

Answer: (C)

The main idea here is how the interest is calculated over time. Simple interest is earned on the original amount invested or borrowed—the principal—every period, so the interest grows in a straight line. Compound interest, however, earns interest on the principal plus any interest that has already been added, so the base for future interest grows each period and the total increases more quickly.

For example, $100 at 5% for three years: simple interest gives $5 each year, totaling $15 and ending at $115. Compound interest adds interest to the balance each year (5% of 105 in year two, then 5% of 110.25 in year three), ending around $115.76. The difference comes from earning interest on previously earned interest in compound growth, which is not how simple interest works.

Other statements misstate the mechanism: one says compound earns only on the initial principal (it doesn’t), another says simple earns on principal and accumulated interest (that would be compound behavior), and the claim that both earn at the same rate over time ignores the impact of reinvesting interest.