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Financial Life Lesson: Debt comes with interest

Now that we know what debt is and how it happens, let’s look at that sidekick that follows debt wherever it goes: interest. And we don’t mean interest as in curiosity, or the interest earned from savings or investments — we mean as a fee. This is an important financial life lesson for your little (and not-so-little) ones to learn early on. Being wary of debt from the start will help your children form strong financial decision-making skills when it comes to taking out loans or borrowing money! Let’s get started.

Teaching elementary-age kids about debt and interest

Ask them to think about the idea of debt a little more deeply with some examples and questions.

  • If you gave a friend $5 today so they could buy a toy, they would have to “promise to pay” you back. In other words, they would have a debt with you.
  • Looking at it a different way: since you gave them $5 of your own money, that’s $5 less that you have for yourself, right? Wouldn’t it make sense for you to get back more than the $5 when they pay you back?
  • Let’s say they pay you back the five bucks in a week — what benefits did you get from lending them the money?
  • Maybe you agree to $6 as the amount they “promise to pay”. You can call it a “thank you” or you can call it a “fee,” but it amounts to interest either way.

You can further explain that interest in the financial sense is the “extra” that is paid back on top of what was borrowed.

Otherwise, the person (or entity) loaning the money does not benefit by lending the money, rather than using it themselves. However, if interest is paid, the person that is making the loan has a reason to loan you the money – they get back more than they gave you!

To keep things simple, you can explain interest as a percentage of what was borrowed. If you borrow $10, the interest might be 10%. That means you, as the borrower, would “promise to pay” $11 back to the loan giver.

Teaching middle-school/teenaged kids about debt and interest

Ask them to think about the idea of debt a little more deeply with some examples and questions.

  • If you gave a friend $25 today so they could buy that PS4 or XBOX ONE game they want right now, they would have to “promise to pay” you back. In other words, they would have a debt with you.
  • Since you gave them $25 of your own money (that’s a lot!) that’s $25 less that you have for yourself, right? What if there’s a game you want to buy today — why would you lend them the money instead?
  • Wouldn’t it make sense for you to get back more than the $25? Maybe you agree to $26 or $27 as the amount they “promise to pay”. You can call it a “thank you” or you can call it a “fee,” but it amounts to interest either way.

You can further explain that interest in the financial sense is the “extra” that is paid back on top of what was borrowed.

  • Otherwise, the person (or entity) loaning the money does not benefit by lending the money, rather than using it themselves. However, if interest is paid, the person that is making the loan has a reason to loan you the money – they get back more than they gave you!
  • To keep things simple, you can explain interest as a percentage of what was borrowed. If you borrow $10, the interest might be 10%. That means you, as the borrower, would “promise to pay” $11 back to the loan giver.

For older kids: advanced concepts of debt, interest, loan payments, and compounding

Let’s say you borrowed $1000 to help you afford your first used car once you turn 16. We’ll assume the interest rate on the loan is 10% (this is high but makes our math easier.)

More than likely, you won’t be able to turn around and pay the full $1100 in the next month. Therefore, you’ll have to make multiple payments on your debt.

This is where debt can get scary. If the agreement was that the remaining debt (balance) after you make a payment compounds by the interest rate of 10%, you could be looking at the following scenario:

Borrow $1000 at 10% compounded monthly. If you pay $90 after the first month, your balance will be $910 x 1.10 = $1,001. Wait… what? You just made a $90 payment and the balance actually went up a dollar from the original loan amount of $1000! At this rate, you’ll never pay off the loan… and it will only grow larger!

The good news is that most interest rates compound annually, not monthly. The point for your child to understand is that the borrower will pay more in the long run than the amount borrowed. Depending on how much is borrowed and what the interest rate is, the borrower could be paying tens of thousands more over time. We’ll see this in action next week.

Teaching kids about debt and interest: tips for parents

You can see where we are going with this. Make sure our elementary students understand the basic concepts of debt and interest. Our middle schoolers and teens need to understand deeper, more advanced concepts such as loan payments and compounding interest. We’ll clarify this a bit more over the next couple of lessons.

Random Fun: 

Phew, all that math has us exhausted. Take a walk around the neighborhood. Challenge the kids to run ahead and hide… but they can’t stray more than 10 feet off of the path. If you walk past them without seeing them, they win!

October 2019

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