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What is Interest? A Lesson for Kids

April 12, 2024
min read

When it comes to teaching our kids about personal finance, some concepts are easier to explain than others.

Saving, for instance, can be easy for even young kids to grasp - you store money in a piggy bank and over time you have more and more money and can make larger purchases you might not be able to buy on a daily basis.

Earning can also be pretty easily explained to our kids and teens - they see their parents go to work every day, they might already have chores they do, so the concept of doing specific activities in exchange for money isn’t something wholly unfamiliar.

Then there are other concepts, like taxes and interest, that are a bit more nuanced. But don’t worry - Till’s here to help on your family’s journey to smarter spending.

Today, we’ll dive into helpful tips for explaining interest to kids. While interest is a concept we’re all familiar with as adults, it’s helpful to break it down into easy bites for younger audiences.

There's interest that earns you money and interest that costs you money.

We find it helpful to think about interest in two ways: there’s interest that earns you money and interest that costs you money.

Let’s dive in!

Interest that earns you money

Interest that earns you money (yay!) comes from vehicles like savings accounts, certificates of deposit (also known as CDs), money market accounts (MMAs), cash management accounts (CMAs), and certain checking accounts.

While the amount of interest you earn differs by account-type, the way you earn interest works pretty much the same - in exchange for parking your cash in one of these account types, the holding bank pays you a small percentage.

Let’s use an example. Say you received $500 for your 13th birthday from your grandparents. Maybe you use some of that money to buy a video game you’ve been wanting and some new sneakers, but you have $400 left and no immediate purchasing needs.

So why not put that $400 into a high-yield savings account that offers a 4.15% interest rate? If you don’t touch that $400 for a year, at the end of the year, you’ll have earned $16.60 in interest.

While that might not seem like a ton of money, it’s pretty good considering you didn’t have to do a single thing but park your extra money in an account and not touch it.

And if you really want to put your money to work, you can regularly add money to whatever account type you’re using, depending on the account, so you can grow interest even faster.

Interest that costs you money

Now for a different type of interest, that’s arguably less fun. The other kind of interest costs you, meaning instead of receiving extra money you have to pay extra money.

Interest that costs you is typically interest associated with a loan. Think lines of credit (including credit cards) and personal loans (like car loans, a home loan, college loans, etc.)

In this case, instead of you holding your money in a bank, you’re asking a bank to let you borrow money you don’t have. The bank wants to be confident that you’ll pay them back (and they’re looking to make some money, too) so they’ll charge you an interest rate that you have to pay, in addition to the amount you borrow.

Example time: you’re saving up to buy a car. The car you’re interested in costs $5,000 and requires a $500 deposit. You have enough saved up for the deposit but you need to take out a loan to cover the rest of the cost ($4,500). In exchange for paying the remaining cost of the car, the lender charges you 5% interest on a 48-month loan. You make monthly payments of $103.63 for the next 48 months.

At the end of the 4-year period when the car is paid off in full, the total amount you’ll have paid the lender is $4,974.33, meaning you ended up paying an additional $474.33 in interest.

There are many situations in which you may decide to take out a loan, like buying a house.

Now this isn’t to say that paying interest isn’t worth it - there are many situations in which you may decide to take out a loan, like buying a house. The important thing is to ensure you’re getting the best rate you can and the best loan term length so that you end up paying as little extra as possible. And also make sure you make all your payments on time!

Credit cards work similarly and can be thought of as another type of personal loan - the credit card issuer lets you borrow as much money as you need (within your credit limit) in a given month and then you pay a bill at the end of every month.

If you don’t pay the full balance, the credit card issuer could charge you interest, every day, on the amount you owe. Credit card debt adds up quickly, so it’s always best to spend within your means and at the very least make your minimum payment every month.

Is that all there is to interest?

While we’d love to say we’ve covered every aspect of interest in this 4-minute read, the truth is there’s a lot more we can dig into. Use this article as an introduction to help your kids understand the foundational basics of what interest is and why it matters for our financial futures.

Stay tuned to dig into the power of compounding interest, the difference between APY and APR, and more interest-related topics with Till.