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It does not make sense to me, data has already been written -- unencrypted -- to C:\ so how can it retroactively change existing data? Does it simply make a copy and delete the original? I thought about that, but wouldn't that require an equal or greater ratio of free:used space? Wouldn't there also be the potential for recovery?

Does it only apply to new newly created files? Almost all encryption programs require you to create a new partition/container.

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Truecrypt does apparently in-place encryption, which of-course requires some free space. As this can fail, the process starts with creating a rescue boot CD.

If you wish to see how it works, this video is for you :
Encrypting The Windows System Partition With Truecrypt 5.0

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