It costs to borrow money.
When a person borrows some money, then he is called a borrower. He needs to pay some extra money during repayment. That extra money during repayment is called interest.
For example: if A takes Rs. 1000 from B. Thereafter, A returns Rs. 1100 to B. It means that A paid (1100 - 1000) = Rs. 100 as interest.
Let us consider the following definitions before proceeding further.
Principal (P) - the money borrowed or deposited for a certain time.
Amount (A) - the sum of principal and interest.
That is, Amount = Principal + Simple Interest
Rate of Interest (R) - the rate at which the interest is charged on principal (always specified in percentage terms).
Time-period (T or N) - the period for which the money is borrowed or deposited.
Types of Interests
Interest can be calculated in two ways: Simple Interest (S.I.) and Compound Interest (C.I.)
Let us see what are S.I. and C.I. ?
Simple Interest: Always calculated as a percentage of the initial principal (P) invested (any time period).
Simple Interest in any year is always constant (i.e. r% of P). So, the principal grows by a constant amount per term.
Compound Interest: Calculated as a percentage of the amount outstanding at the start of the time period (and not the initial principal).
So, interest earned in earlier time periods keeps on getting added to the initial principal and this new sum is considered to be reinvested and interest is calculated on this new amount.