It may be defined as "the paid money for the use of borrowed capital".
It may also be defined as "the income produced by money which has been loaned".
This can be explained by the following example:
Suppose Mr. A comes to Mr. B and desires to borrow Rs. 1000 saying he will return it after one year. Mr. B has Rs. 1000 in his pocket, in which he had planned to purchase a few luxuries which he does not now posses. He decides that it would not be too bad to go without these luxuries, if Mr. A would promise to pay him something extra for his doing without these personal pleasures for a year. He thinks that Rs. 100 would be a fair price for this year of sacrifice on his part.
He quickly remembers that although he has known Mr. A for some time and believes he is entirely honest. Human nature has its weakness and there is some possibility that Mr. A might run off and not repay what he has borrowed. Also he remembers how many innocent people are killed by accident each year and realizes that this might happen to his friend so he would not see back his money.
He feels that he should also be paid some money for his risk. He thinks an additional Rs. 50 to be paid for his risk. He tells to Mr. A that he will be glad to let him use Rs. 1000 for a year, if Mr. A will promise to give him back Rs. 1150 at the end of the year, Mr. A agrees to do this, and the deal is made. The extra Rs. 150 which Mr. B receives at the end of the year are said to be the interest which he earn from his Rs. 1000 investment.
Interest is of two kinds:
(i) Simple interest and
(ii) Compound interest.
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