Compound interest is collected based on the total loan balance, including principal and accrued but unpaid interest (interest charged on the loan but not paid). Therefore, compound interest involves charging interest on interest.
If the loan balance starts at $10,000 and the interest due in one year is capitalized, the new loan balance becomes $10,500 ($10,000 + $500), and the accrued interest for the second year is $525 (10,500 x 0.05).