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Natraj Vannavada

Interest is the amount the borrower pays the lender at regular intervals of time until he pays back the original principal amount.

Interest is calculated on the principal amount that an individual / entity borrows as part of Loans based of a interest rate.
Interest can be calculated on the principal as a straight forward simple interest, or a little more complex compound interest.

Simple Interest

This is something like a flat rate that you pay on the balance amount of the loan. The monthly payments are distributed appropriately and go towards the principal and interest every month at a constant ratio. Interest for the next month is calculated solely based on the principal balance at that point of time and usually goes down gradually while the loan is being paid off.

Formula to calculate simple interest

Principal = P
Annual Rate of Interest = R (expressed as %, annual rate)
Time period = T (in number of years)
Interest per year = I

I = (P*T*R)

Compound Interest

This on the other hand is calculated on the sum of principal and also the interest amount accrued over a period of time until the next payment.

Example, a loan of $10,000 compounded annually at a rate of 10% interest for a term of 2 years would be

Year Balance
Now $10000
1 $10000 + (10*10000)/100 (total = $11000)
2 ($10000 + (10*10000)/100) + 10($10000 + (10*10000)/100) (total = $12100)

So the total interest that the borrower would have paid would be $2100 apart from the principal amount.

Formula for compound interest

Principal = P
Annual Rate of Interest = R (expressed as %, annual rate)
Time period = N (in number of years)
Interest per year = I

I = P*(1+R)^N