Module 2: Understanding Interest (Basic Concepts) for Kids

FINANCIAL LITERACY LEARNING RESOURCES 

Understanding Interest 

Interest can seem like a tricky idea, but it’s actually quite simple when we break it down. It’s a basic concept that affects many areas of our lives, from saving money to borrowing it. Whether you’re saving up for something special, like a new toy or a video game, or borrowing money to buy something, understanding how interest works can help you make smart financial decisions. Let’s dive deeper into what interest is, how it works, and why it’s important for both saving and borrowing.

1. What is Interest?

Interest is like a reward or a cost that you pay or receive when you borrow or lend money. Think of it this way: if you lend your friend some money so they can buy a snack, they might say, “I’ll give you back an extra dollar as a thank you.” That extra dollar is interest. When you lend money, you get a reward for letting someone use it. On the flip side, when you borrow money from someone else, you might have to give them back extra as a fee for using their money. This fee is also called interest.

Interest can work both ways. You either earn interest when you save or lend money, or you pay interest when you borrow it. But no matter what, interest always involves that extra amount of money, which can grow over time.

2. Types of Interest: Simple and Compound

There are two main types of interest: simple interest and compound interest. Both types work differently, and understanding them can help you know how your money will grow or what you’ll owe when borrowing.

a. Simple Interest:

Simple interest is the easiest type of interest to understand. It’s when you earn or pay the same amount of interest every single time. For example, let’s say you save $100 in a bank, and the bank gives you a 5% simple interest rate. At the end of the year, the bank will give you $5 as interest (because 5% of $100 is $5). Each year, as long as you don’t add or remove any money, the bank will keep giving you that same $5. It’s simple because the interest doesn’t change—it’s always the same amount.

Here’s another example. Imagine you lend your friend $50, and you both agree that they’ll pay you 10% interest every year. At the end of the year, your friend will give you an extra $5 (because 10% of $50 is $5). If they haven’t paid you back the original $50 by the second year, they will owe you another $5 for the second year. Simple interest stays the same over time.

b. Compound Interest:

Now, compound interest is a bit more exciting! It’s a way of earning interest not just on the money you originally saved or lent, but also on the interest you’ve already earned. Let’s use an example to make this clearer.

Suppose you save $100 in the bank, and the bank offers a 5% compound interest rate. In the first year, you’ll earn $5 in interest, just like with simple interest. But in the second year, you earn interest on both the original $100 and the $5 you earned as interest in the first year. So, instead of earning just $5 in the second year, you’ll earn a little more—$5.25. Over time, as the interest keeps building on top of the interest from previous years, your money grows faster. This is why compound interest is sometimes called “interest on interest”!

If you keep your money in the bank long enough, compound interest can really make your savings grow. It’s like a snowball that gets bigger and bigger as it rolls down a hill. The longer it rolls, the bigger it gets. Compound interest works the same way—the longer you leave your money in the bank, the more it grows.

3. How Interest Affects Saving

When you save money, interest helps it grow. This is one of the main reasons why people save their money in banks. Banks are like a safe place to keep your money, and in return for keeping it there, the bank gives you interest. It’s like a reward for letting the bank use your money. But what does the bank do with your money?

Banks don’t just keep your money sitting there. They use it to lend to other people who need to borrow money, like when someone wants to buy a car or a house. In return for borrowing the money, those people pay the bank interest. The bank takes part of that interest and gives it to you because it was your money that helped them make the loan. So, the longer you leave your money in the bank, the more interest you’ll earn, especially with compound interest.

a. Simple Interest Savings Example:

Let’s imagine you have $100, and you decide to save it in a bank that offers 3% simple interest each year. Here’s what would happen over five years:

• Year 1: You start with $100, and at the end of the year, you earn $3 in interest. Now, you have $103.

• Year 2: You earn another $3 in interest, so now you have $106.

• Year 3: You earn $3 again, making your total $109.

• Year 4: You earn $3 once more, bringing your total to $112.

• Year 5: You earn $3 again, so now you have $115.

Over five years, you earned a total of $15 in interest, and your savings grew to $115.

b. Compound Interest Savings Example:

Now, let’s look at how compound interest can make your savings grow faster. Suppose you save the same $100, but this time the bank offers 3% compound interest each year. Here’s what happens over five years:

• Year 1: You earn $3 in interest, so now you have $103.

• Year 2: You earn 3% interest on $103, which gives you $3.09. Now you have $106.09.

• Year 3: You earn 3% interest on $106.09, which gives you $3.18. Now you have $109.27.

• Year 4: You earn 3% interest on $109.27, which gives you $3.28. Now you have $112.55.

• Year 5: You earn 3% interest on $112.55, which gives you $3.38. Now you have $115.93.

With compound interest, your total after five years is $115.93—almost a dollar more than what you earned with simple interest. It may not seem like a lot at first, but over many years, that extra interest can add up!

4. How Interest Affects Borrowing

Just like interest can help your money grow when you save, it can also make things more expensive when you borrow. When you borrow money, whether from a bank, a friend, or a company, they usually charge you interest as a fee for borrowing their money. This means you have to pay back more than what you borrowed.

a. Borrowing with Simple Interest:

Let’s say you borrow $100 from a friend, and they charge you 10% simple interest each year. If you don’t pay them back for two years, here’s what happens:

• Year 1: You owe 10% interest on $100, which is $10. So now, you owe your friend $110.

• Year 2: You owe another 10% on the original $100, which is another $10. Now, you owe $120.

If you wait two years to pay your friend back, you’ll owe them $120 instead of just $100. That extra $20 is the interest.

b. Borrowing with Compound Interest:

Borrowing with compound interest can get expensive quickly. Let’s say you borrow $100 with 10% compound interest each year. Here’s how much you would owe after two years:

• Year 1: You owe 10% interest on $100, which is $10. Now, you owe $110.

• Year 2: You owe 10% interest on $110, which is $11. Now, you owe $121.

With compound interest, you owe $121 after two years—$1 more than with simple interest. While that may not seem like much, compound interest can add up fast if you borrow money for a long time.

5. Why is Interest Important?

Interest is important because it helps people make decisions about money. If you’re saving money, interest can help you grow your savings. The longer you save, the more interest you can earn, especially with compound interest. This can be really helpful when you’re saving for something big, like a new bike or a special trip.

On the other hand, if you’re borrowing money, it’s important to understand how much interest you’ll have to pay back. Sometimes, borrowing money is necessary, like when you need to buy something expensive or pay for school. But because interest can make borrowing more expensive, it’s important to borrow wisely.

Conclusion

In summary, interest is a key concept in both saving and borrowing money. Whether you’re earning interest on your savings or paying interest on a loan, understanding how it works can help you make smart financial choices. Simple interest gives you a steady, predictable amount, while compound interest helps your money grow faster over time. Knowing the difference between these two types of interest can help you plan for your future