What is compounding in the context of interest?

Compounding in the context of interest refers to the process where earned interest is added to the principal balance of an account. This means that not only does the original amount of money generate interest, but the interest that accumulates also earns interest over time. This can lead to exponential growth of the investment or savings over the long term because each interest calculation is based on an increasingly larger total.

In contrast, the other options describe different concepts that are not related to the definition of compounding. For example, paying interest on loans refers to the cost of borrowing money, reducing the principal amount involves decreasing the original loan or investment amount, and calculating average daily balances pertains to the method of measuring account activity rather than how interest accumulates. Thus, understanding compounding as the addition of earned interest to the principal is critical for grasping how savings and investment growth can be maximized over time.