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This article is from a series of articles about giving your children the life-skills necessary to effectively manage their money. To go to the table of contents, click here.

Understanding Interest

Understanding interest is another important part of your family's financial education. Both the interest you earn on savings and investments and the interest you pay on your outstanding debt are good lessons for all children.

When your child has learned to multiply, it's time for you to explain the basics of interest. Refer to the examples below to help in educating your child:

Interest - the cost of borrowing or lending money - is expressed as a percentage of the amount involved. This amount is known as the principal.

For example, if you borrow $1,000 (principal) at 10 percent (interest rate) for one year, you must pay back $1,100 - the $1,000 borrowed and $100 in interest.

If you borrow money for two years, you will probably have to pay a higher rate of interest. This is because interest rates are more likely to change over a longer period of time, and that means a greater risk for the lender. If the interest rates were 13 percent for a two-year loan, the borrower would have to pay the lender $130 each year, in addition to the $1,000 principal.

When you open a bank account, you are, in effect, lending money to the bank. The bank pays you (the depositor) interest and lends the money to someone else at a higher rate. This is how the bank makes a profit.

Interest charges often vary for consumer credit, credit cards, store credit cards and mortgages. If interest rates go up, borrowers have to pay more. If they go down, borrowers have to pay less. The same holds true for savings accounts: if interest rates rise, the savers earn more on their money; if they fall, savers earn less.

Compounding interest is when you earn interest on interest earned or pay interest on interest charged. For example:

  • $1,000 dollars put into a savings account that earns 5% and compounds interest annually will earn $50 interest for you in the first year (1000 x .05 ) and $52.50 ($1050 x .05) the second year. When you earn interest on previously earned interest, you are experiencing compounding of interest. The compounding frequency defines how frequently interest is computed. For example, if the savings account compounded interest semi-annually, you would have earned:

  • $25.00 ($1000 x .05 x 6/12 (6 months in bank when interest calculated) )

  • $25.66 ($1026.25 x .05 x 6/12)

  • $50.66 in year one. $0.66 more than when compounded only once per year.

  • When you have a debt of $1000 that has loan rate of 10%, you owe the lender $100 per year on the loan (1000 x 10%), assuming the debt compounds on an annual basis. If you pay less than $100 toward the loan in the first year, you will owe more than the $1000 you originally borrowed. Assuming that you repaid $80 in year one, you would owe $1020 in year two and your interest charges in year two would be $102 ($1020 x .10) rather than $100 dollars. Point out to your child how your debt is actually increasing when you do not repay at least the interest you owe and that the interest payments will last forever (draining your savings) until you begin paying more than the interest that you owe.

Provide several examples for your child that demonstrates how quickly money can grow because of compounding of interest.

When your children are younger, you can demonstrate these concepts by using coins and playing that your child is the banker and has given you a loan. Make learning about money fun and your child will get so much more from it!