Trying to encourage your kids to save money? Explaining how interest works might make them more enthusiastic. Plus, raising financially literate kids is important. It means they’ll be able to make responsible decisions about saving, investing and borrowing as adults.
Here’s how to talk to your kids about interest in terms they’ll understand.
Related: Financial literacy for kids
What is interest?
Interest is money you earn on your savings. The bank pays you interest as a thank-you for letting them use your money to invest or lend to other customers. You also pay interest when you borrow money. To buy a house, for example, or a car, or on credit cards.
It might help to get your kids to think of interest as a reward for saving money or the cost of borrowing it.
Interest gets paid at a certain rate, called an annual percentage rate (APR for short).
Suppose you pay £100 into a savings account with an APR of 5%. Five percent of £100 is £5. At the end of the year, you’ll have £105. Moreover, the longer you leave money in your savings account, the more interest you’ll earn.
Formula for interest
To work out interest, you multiply your starting balance by the interest rate and the length of time. There’s a formula for calculating interest. It looks like this: I = P x R x T
To help your kids understand the formula, you may need to explain what each letter stands for.
I — interest
P — principal (the amount paid into savings or the amount borrowed)
R — the rate of interest (a percentage written as decimals, so 15% is 0.15)
T — time (the length of time the money is borrowed for, or how long it has been on deposit).
Next, give them an example. Say you pay £100 into your savings account, and you want to know how much interest you’ll earn in five years at an interest rate of 5% per year.
Your principal amount, P = £100
The rate of interest, R = 5% = 0.05
Time, T = 5 years
Using the interest formula: I = P x R x T your calculation will look like this:
I = 100 x 0.05 x 5 = 25
After five years you’ll have earned £25 in interest. So your total savings will be £125.
To encourage your child to save, use a larger principal. For example, £10,000 at an APR of 5% over five years will earn you £2,500 in interest. So your total savings will be £12,500.
How interest works when borrowing
When you borrow money, you have to pay back the principal (the amount you borrowed). You also have to pay interest to the lender.
The easiest way to explain this is to give your kids an example.
Let’s say you want a new pair of trainers, but they cost £60, and you only have £10 saved. Your friend offers to lend you the £50 you need to buy the trainers but says you have to pay interest at 10% for borrowing the money. The total amount you’ll have to pay back to your friend will be £55 (£50 + £5 interest).
How interest works when lending
When banks lend you money, they have to decide how much interest you’ll pay on the loan. To work this out, they look at things like:
Your credit score
The cost of servicing your account
How much interest the bank is paying to get the money they’ll lend you.
A credit score is a 3-digit number based on your financial history. The higher your score, the more confident lenders will be about letting you borrow money from them.
Get your children to think of it this way: you’re more likely to lend things to friends you know will return them. Then give them an example.
Suppose you want to borrow £500 from the bank. To calculate your loan interest rate, the bank starts with the amount of interest they have to pay to get the money for you (say 4%). Next, they check your credit score to ensure you are a person likely to pay the money back.
You’re good for the loan, but the bank still needs to make a profit, so they add another 2%. Your interest rate on a £500 loan will be 8%.
When you’re sure your child understands interest, you could go on to talk about compound interest.
Related: How to teach your child about credit
The difference between interest and compound interest
Interest is money you earn on your savings or pay for borrowing. Compound interest is money you earn on both the money you save and the interest you earn on that saving. So every year you earn interest, you also earn interest on the interest itself.
Compound interest is great when you’re saving. To explain, use an example.
Imagine you paid £1000 into a savings account with an annual interest rate of 10%.
By the end of the year, you’ll earn £100 in interest, making your total £1100.
The following year, you’ll earn £110 in interest (10% of the original £1000 and 10% of the year one interest), making your total £1,210.
The year after, you’ll earn £121 in interest (10% of the original £1000 and 10% of the year two interest), making your total £1,331 and so on.
Compound interest is not so great when you borrow. Compounding debt interest can seriously add up when you borrow large sums of money over a long period. It can end up costing you a lot more.
When do you pay interest?
You’ll pay interest on several different types of borrowing. Here are some examples.
Credit cards. You’ll get charged interest if you don’t pay your monthly credit card statement in full.
Mortgages are loans to buy houses. They’re usually long-term loans you repay over 25-30 years. You’ll pay interest at a fixed or variable rate (which changes during the loan period). But your interest payments should reduce over time as you gradually pay off your original loan amount.
Car loans. You might take out a bank loan when you borrow money to buy a car. Or take out an auto loan offered by a car dealer. Auto loans are short-term loans of up to six years, and interest is usually charged at a fixed rate.
Student loans. Loans for university education are currently capped at an interest rate of 6.5%. Paying off a student loan and the interest depends on your salary and the threshold for your monthly income.
Invoices. Some firms charge you interest instead of late fees if you don’t pay your invoice on time.
When do you earn interest?
You earn interest on money in savings accounts and some current accounts. There are several different kinds.
Regular/traditional savings accounts. Most traditional banks and building societies offer regular savings accounts.
HIgh-yield savings accounts. Banks also offer high-yield savings accounts. They pay higher interest rates but may tie your money into a set period of time.
Pension savings account. There are different types of pension accounts with varying long-term interest rates. You can also open a child pension account, which is a long-term savings account with interest.
Kids’ savings accounts. These are designed for kids under 18 and must be opened by a parent or guardian who acts as a joint account holder.
Cash ISAs. Unlike a stocks and shares ISA, where the gains come from the ebb and flow of the stock market, cash ISAs, pay a set rate of interest which could either be variable and subject to change by the bank or building society, or fixed for a certain period – say, one or five years.
Why are there different interest rates?
Interest rates are affected by factors like economic growth, inflation, and monetary policy. The bank rate, which influences other interest rates, is set by the Bank of England.
In simple terms, interest rates go up and down because of supply and demand. The demand by borrowers and the supply of funds available to lend.
For example, a bank may have to raise its interest rates on savings accounts if many want loans. They hope higher interest rates will attract more savers, so they have money to lend to other people.
Have fun teaching your kids about interest
Teaching kids about money doesn’t have to be dull. Depending on their age, you can explain what interest is to kids in fun ways. Here are some ideas
Play a game — To demonstrate the power of compound interest (and teach delayed gratification), give your child a sweet. Tell them they'll get another piece if they haven’t eaten it after an hour. If, after another hour, they haven’t eaten those, they’ll get two more sweets and so on. Just make sure you have enough sweets if they keep going!
Make it an activity — Another way to show kids the value of compound interest is to ask, “would you rather have a penny and double your money daily for 30 days or have £1 million”. They’ll probably answer £1 million but help them do the maths. Start at one penny and double it 30 times. By day 28, that penny will have become £1,342,177.28. By day 30: £5,368,709.12.
Pay interest on your child’s pocket money. Explain to your child that if they save 50% of their pocket money weekly for a month, you’ll reward them with interest matching what they save. If they get £5 a week and save £2.50 for four weeks, they’ll have £10 saved by the month’s end plus £2.50. So £12.50 in total.
How can GoHenry help teach your children about interest?
GoHenry makes it easy to show your child how interest works. A pre-paid kids debit card and app available for kids aged 6-18, GoHenry comes with Money Missions, which helps your child learn about savings, investments and interest and how it works.
A companion app for parents. allows you to put their learnings into action with savings goals and parent-paid interest on your child’s savings.
Money Missions on the GoHenry app are a great way to build your kids’ financial confidence too. Through fun, bite-sized, interactive games and quizzes they’ll learn everything from healthy saving habits to spending wisely, investing, budgeting and more.