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When you lend money to another person, the borrower usually pays a fees to the lender. This fees paid is called the interest. Similarly, you also earn interest on the money you deposit with the bank. Interest can be of two types simple interest and compound interest.

Simple Interest

Simple interest is calculated per year and it depends on the rate of interest. The rate is usually defined per annum ( same as per year ).
The original amount is referred to as the Principal.

Simple interest can be calculated using the formula
Simple interest = Principal * rate of interest * time

Where time is the amount of time for which we wish to calculate the interest.
The rate of interest is usually expressed as a percentage hence we must convert it into a decimal in our calculations.

Practice questions
Question: Neil deposits an amount of Rs. 1000 with the bank for 1 year. If the rate of interest is 5 % how much is the interest that Neil will get at the end of the year? Also how much is the total balance in his account at the end of the year?
Principal    =     Rs. 1000
Time (years)    =    1 year
Rate of interest = 5 % = 0.05
Simple interest = Principal * Time * Rate of interest
= 1000 * 1 * 0.05
= 50 Rs.
Total balance in account     = Principal + interest
= 1000 + 50
= 1050 Rs.
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Compound interest

Compound interest is paid on the amount already earned thus leading to greater and greater amounts of interest over a period of time. Let us take a look at some compound interest questions and answers.

Practice questions
Question: Rhea deposits \$800 in the bank. The rate of interest is 5% compound interest per year. If she keeps the amount in the bank for 2 years, how much is the total amount in Rhea’s account at the end of the second year?
Principal    = \$800
Rate of interest= 5%
Time        = 2 years

Interest at the end of the first year = 800 * 0.05 * 1 = 40\$
Therefore Principal for the second year = 800 + 40 = 840\$
Interest at the end of the second year = 840 * 0.05 * 1 = 42\$

Total amount in the bank at the end of the second year = 840 + 42 = 882 \$
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Question: £800 is deposited in a bank paying 2% compound interest per annum. What is the balance after 3 years?
Principal = £800
Rate of interest = 2%
Time = 3 years

Interest at the end of the first year = 800 * 0.02 = 16 £
Principal for the second year = 800 + 16 = 816 £

Interest at the end of the second year = 816 * 0.02 = 16.32 £
Principal for the third year = 816 + 16.32 = 832.32 £

Interest at the end of the third year = 832.32 * 0.02 = 16.64 £
Amount balance after 3 year = 832.32 + 16.64 = 849 £
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