Explain how compound interest affects savings versus debt over time.

Explain how compound interest affects savings versus debt over time.

• A. It earns interest on interest for savings; for debt, interest accrues on principal and past interest.
• B. It only affects savings.
• C. It reduces the balance of debt automatically.
• D. It has no effect on debt or savings.

Answer: (A)

Compound interest means earning interest on previously earned interest. In savings, that makes your balance grow faster over time because you’re accumulating interest not just on the original deposit but on the interest that has already been added. For example, $100 at 10% compounding annually becomes $110 after one year and about $121 after two years, even without adding more money. For debt, compounding works the same way but it increases what you owe. If you borrow $100 at 10% compounding yearly and don’t pay anything, you’d owe about $110 after the first year and about $121 after the second year. You’re paying interest on both the original principal and the past interest, so the debt grows more quickly. More frequent compounding (monthly, daily) speeds up both growth in savings and the increase in debt. The key idea is that compounding makes interest accumulate on interest, turning growth or debt into a faster, exponential process.

Compound interest means earning interest on previously earned interest. In savings, that makes your balance grow faster over time because you’re accumulating interest not just on the original deposit but on the interest that has already been added. For example, $100 at 10% compounding annually becomes $110 after one year and about $121 after two years, even without adding more money.

For debt, compounding works the same way but it increases what you owe. If you borrow $100 at 10% compounding yearly and don’t pay anything, you’d owe about $110 after the first year and about $121 after the second year. You’re paying interest on both the original principal and the past interest, so the debt grows more quickly.

More frequent compounding (monthly, daily) speeds up both growth in savings and the increase in debt. The key idea is that compounding makes interest accumulate on interest, turning growth or debt into a faster, exponential process.