Talk financial terms with your teens – Part 4

Finding interest is interesting. Learn how interest and compound interest can work for and against you.

In Part 1, Part 2 and Part 3, we discussed many financial terms teens should know. These may be familiar terms and some teens may already have experience calculating them, but they might not know the hidden secrets they hold. If your interest is peeked, let’s get to the bottom and top of interest.

Interest

Simple and compound interest can be found on your investment or a loan. It is the payment from the borrower of the money. It is not a set fee, but it is payment from using the money. The borrower pays back the initial amount borrowed, the principal amount, plus a percentage. This can be calculated over a period of time.

An example of simple interest is: You loan out \$500 and you ask to be paid 7% monthly to use it. For one month it is \$500 x 1.07 = \$535 (the \$500 principal + \$35 in interest). If you do this over one year, you add \$35 each month; 12 x \$35 = \$420. The \$500 loan would make \$420 on your initial \$500 investment. This means, after a year you get \$920! Now, this is a basic example with a great interest rate, and the risk you take is who you loan it to, and you could have used that \$500 some place else.

Of course this works the other way too. If you are requesting a loan, the bank or institution granting the loan will charge you interest. You are using their money. They want that money back plus interest. Make sure youth know what they are signing and expecting to pay.

Compound interest

“Money makes money. And money that money makes, makes money.” Ben Franklin said this referring to compound interest. It may seem confusing, but it can be very powerful. The idea is that the interest you get on the principal is reinvested and calculated again at the interest rate agreed upon and time (compounded annually, monthly, quarterly, etc.). Here is how it works.

Let’s start with the example we used above. You loan out \$500 at 7% interest paid out monthly. You received payments each month; 12 over a year at the same rate. If you now apply compound interest monthly for one year, you reinvest that money and recalculate it each month. The first month is \$500 x 1.07 = \$535. The second month is \$535 x 1.07 = \$572. The third month is \$572 x 1.07 = \$612, and so on. At the end of the year, you would receive approximately \$1,126. Your original investment money of \$500 made you \$626 in a year!

Again, this is just a simple example with rounded figures and with a great interest rate, but you can see the growing effects of this tool. Now imagine if a teenager were to invest this at a young age and let it compound for 30 or 40 years!

There are new terms coming into play all the time and it is tough to keep up with all the jargon and terminology. However, if you continue to talk with your children about money and how best to handle it, they will be much better playing the game and not getting sidelined with money woes.

For more information on fiscal management or youth money management, please visit the Michigan State University Extension and Michigan 4-H Youth Development websites. Other resources you may find useful include the “Financial Manual for 4-H Volunteers: Leading the Way to Financial Accountability” and the “Financial Manual for 4-H Treasurer: A Guide to Managing Money Wisely.” As a part of our work, Michigan State University Extension provides financial literacy programming.