What Is Interest? How Can it Work for and Against You?

Interest Is a Great Way to Make (Or Lose) Money.

Mother watching daughter count coins from piggy bank. Tom Merton

What Is Interest?

Interest payment in exchange for the use of money over time. You can earn interest by lending your money to a bank. In addition, you pay interest when you borrow money from a bank. The rate of payment can either be fixed or variable throughout the life of the loan or deposit. 

Examples:

  • When you open a savings account at a bank, the bank will pay you to keep your money on deposit at their bank. Interest is the payment you receive.

Two Kinds of Interest

There are two ways in which interest is calculated.

  • Simple interest is a percentage based on the amount of money you deposit. For example, if you deposit $100 at 2% interest paid semi-annually, you will receive $2 twice a year for a total of $4in interest earnings per year. 
  • Compound interest is more... interesting! The bank starts out by paying you $2 based on the $100 you deposited--but your next payment will be based on the total amount you've accumulated ($102). That may not seem like a huge increase, but over time compound interest can be a very easy and effective way to make money on your money.

The Surprising Power of Compound Interest

Few kids are intrinsically fascinated by banks and savings-- but the power of compound interest may grab their interest. How quickly will their money double without their lifting a finger?

They can quickly calculate the answer (with or without your help) with a tool called "The Power of 72."

  1. Find the rate at which you will be earning interest (let's say it's 6%).
  2. Divide 72 by that number (72/6 = 12) -- so it will take 12 years to double your money.
  3. Select an amount to deposit. Between birthday money, personal earnings, and other sources, imagine your 10-year old has $3,000.
  1. What's 3 X 2?  In 12 years, without doing a thing, your child will have doubled his money--meaning he or she will have a nice little nest egg of $6,000 to draw on at age 22.

The Negative Side of Interest

While your child will no doubt be delighted to hear that he or she can easily earn interest, they'll be less thrilled to hear about the negative impacts of interest that they will likely owe as adults. Not only will they owe interest on major purchases such as cars and houses, but they will also owe very high interest if they don't pay off their credit cards monthly.

Now that they understand the likely rates of interest they can expect to earn (rarely more than 5% from a bank, for example), 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 wish to share some tips for keeping interest rates lower:

  • use credit cards sparingly, and pay off balances each month;
  • look carefully for low-interest loans and financing;
  • avoid "too good to be true" options (the kind that are often advertised on the Internet and over the phone);
  • be sure that anyone you borrow from or loan to is reputable. 

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