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### Understanding Compound Interest

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An interest rate is described as simple if it pays the same amount each period. For example, if you have $1,000 in an investment that pays a simple interest rate of 10% per year, you'll receive $100 each year.

Suppose, however, that you were able to add the interest payments to the investment. At the end of the first year, you would have $1,100 in the account, which means that you would earn $110 in interest (10% of $1,100) the second year. Being able to add interest earned to an investment is called compounding, and the total interest earned (the normal interest plus the extra interest on the reinvested interest—the extra $10, in the example) is called compound interest.