The entire file system is encrypted (i.e., file names, folder names, contents of every file, and free space). Until decrypted, a TrueCrypt volume appears to be nothing more than a series of random numbers.
No data stored on an encrypted volume can be read (decrypted) without using the correct password or correct encryption key. On-the-fly encryption means that data are automatically encrypted or decrypted right before they are loaded or saved, without any user intervention. TrueCrypt is a software system for establishing and maintaining an on-the-fly-encrypted drive.
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