Compound interest, on the other hand, is calculated on the initial principal and also on the accumulated interest of previous periods. This means that interest is earned on both the initial amount and the interest that has been added in previous periods. For instance, if you invest $1,000 at an annual compound interest rate of 5%, the interest for the first year would be $50. However, in the second year, the interest is calculated on $1,050, resulting in $52.50 in interest for the second year.