In its purest definition, interest is a payment in exchange for the use of money over a period of time. You can earn interest by lending your money to a bank. Conversely, you pay interest when you borrow money from a bank. The rate of payment can either be a fixed amount or a variable amount throughout the lifetime of the loan or deposit.
Two Examples of Interest Received and Interest Paid
- When you open a savings account at a bank, the bank pays you to keep your money on deposit at their bank. Interest is the payment you receive from the bank.
- When you take out a mortgage to purchase a house, you pay interest to the bank for the use of the money borrowed for the purchase of your home.
Simple vs. Compound Interest Calculation
There are two ways in which the interest on a savings account or a loan is calculated. Interest can be either simple or compound.
This interest is figured at a flat percentage. With savings accounts, it is often based on the total amount of money you deposit. For example, if you deposit $100 at 2% interest paid semi-annually, you receive $2 twice a year for a total of $4 of interest earned each year. You will also see this type of interest calculation used for some types of bonds.
Compound interest is more interesting and a bit more complex to calculate. Here, the interest from one month is added to the total principal amount of the loan or account and is accessed interest in the following month. In other words, it builds with each passing calculation period.
Say a bank starts out by paying you $2 based on the $100 you deposited. However, your next payout is based on the total amount you have accumulated in the account, $102. This may not seem like a huge increase, but, over time, compound interest is an easy and effective way for you to make money on your money.
The Surprising Power of Compound Interest
Few children are intrinsically fascinated by banks and savings. However, the simple math and power of compound interest may grab their interest. If you want to teach your child how quickly they can double their money without their lifting a finger, have them calculate the answer (with or without your help) using a tool called "The Rule of 72."
- Find the rate at which interest is being earned. Let's say it's 6%.
- Divide 72 by that number (72/6 = 12) and you'll see it will take 12 years to double your money.
- Begin the exercise by selecting an amount to deposit. Between birthday money, personal earnings, and other sources, let's say your 10-year-old has $3,000.
- Once you multiply 3,000 by 2, in 12 years, without doing a thing, your child will have doubled their money and have accrued a nice little nest egg of $6,000 by age 22.
The Negative Side of Interest
While your child will no doubt be delighted to hear that they can easily earn interest, they'll be less thrilled to hear about the negative impacts of interest they'll owe as adults on money borrowed. Not only will they owe interest (on major purchases such as cars and houses) but they will owe very high interest if they don't pay off their credit card debt monthly.
Now that your child understands the rates of interest they can expect to earn (rarely more than 5% from a bank), you may want to explain that the rates of interest they can owe can be even higher than 20% (on some credit cards, depending upon credit rating and other factors).
At this point, you may want to offer the following tips for keeping interest rates low:
- Use credit cards sparingly and pay off balances each month.
- Look around for low-interest loans and financing.
- Avoid "too good to be true" options, often advertised on the internet and over the phone.
- Be sure anyone you borrow from, or loan to, is reputable.