What is interest? Explaining to your kids in simple terms

What is interest? Explaining to your kids in simple terms

 

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).  

 

Let’s say 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. What’s more, 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 — 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 sneakers but they cost $60 and you only have $10 saved. Your friend offers to lend you the $50 you need to buy the sneakers 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 add your account servicing cost (2%). And finally, they check your credit score. 

 

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 how, 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. When you borrow large sums of money over a long period, compounded debt interest can seriously add up. 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 off in full. When you borrow money on credit cards you pay much higher interest rates. 

  • Mortgages — 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 rate or a variable rate (one that changes during the loan period). But your interest payments should reduce over time as you gradually pay off your original loan amount.  

  • Auto loans — When you borrow money to buy a car you might take out a bank loan. 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 — Federal loans for college education range from 4.99-7.54%. Average private student loan rates can be anything from 4-15%. Paying off a student loan can take anywhere from 10-30 years. It depends on the type of loan and repayment term you choose. 

  • 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 checking accounts. There are several different kinds. 

 

  • Regular/traditional savings accounts — Most traditional banks and credit unions offer regular savings accounts. However, the interest rates are often low compared to other savings options. And monthly fees may cancel out your interest earnings.

  • HIgh-yield savings accounts — Online banks and credit unions offer high-yield savings accounts. As well as paying higher interest rates, they often have low minimum deposits. But you may not be able to withdraw cash from ATMs.

  • Money market accounts (MMAs) — Traditional banks, online banks, and credit unions offer MMAs. Some offer rates similar to high-yield savings accounts and you can often write checks or withdraw cash from ATMs too. High minimum deposits may be required. 

  • Certificate of deposit (CD) account — Traditional and online banks offer CD accounts. They’re best for people who don’t need to access their savings right away. CDs range from 30 days to 60 months. You’ll pay a penalty if you withdraw early.

  • Retirement Savings account — There are different types of retirement accounts: traditional and Roth IRAs as well as IRA CDs. You can also open accounts to help you save for healthcare, like Flexible Spending Accounts (FSA) or Health Savings Accounts (HSA). Most banks, credit unions, brokerages or investment companies offer these.

  • 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. Kids’ savings accounts usually come with extra perks. Such as no monthly fees and low to no opening balance requirements.

  • Custodial accounts — If you open a custodial account for your child, money in the account is owned by your child, but they can’t access it until they turn 18. 

  • Education savings accounts — These are designed for parents to set aside money for their children’s college education. 529 and Coverdell accounts are tax-advantaged savings accounts too. 

Why are there different interest rates?

Interest rates are affected by factors like economic growth, inflation, and US monetary policy. Target interest rates are set by the Federal Reserve, but they can vary from bank to bank and state to state. 

 

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, if lots of people want loans, a bank may have to raise the interest rates they offer on savings accounts. 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 interest 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 piece of candy. Tell them if they haven’t eaten it after an hour they’ll get another piece. If, after another hour they haven’t eaten those, they’ll get two more bits of candy and so on. Just make sure you have enough candy 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 math. Start at one cent and double it 30 times. By day 28 that cent will have become $1,342,177.28. By day 30: $5,368,709.12. 

  • Pay interest on your child’s allowance — Explain to your child that if they save 50% of their allowance every week 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 debit card and app available for kids aged 6-18, GoHenry comes with a companion app for parents. As well as setting savings goals and spending limits, you can set up 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. 

 

 

 

 

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Written by Charlotte Peacock Published Mar 13, 2023 ● 8 min. read