How Interest Works

I once heard someone say, “Ask a question, and be a fool for five minutes. Don’t ask, and be a fool forever.” That principal works so well in money. The fact of the matter is someone can tell me all of the details about a Roth IRA...and yet know nothing about how interest works. Or someone could be on top of all of their credit card transactions...and yet know nothing about buying and owning a house. I’ve noticed that oftentimes, if someone would just know basic principles of money, they would be so much better off in our world!

So it is with that that I have made this website. I want you to understand how money works...even down to the most basic of principles. If you don’t understand how interest works, that is fine! But do something about it. That is the entire purpose of this specific article...let’s now turn our interest towards interest!

Picture a cute kid sister going into a store with her older brother. The sister sees a pack of bubble gum that she really wants. But she is young, and she has no job. And she has already spent her monthly allowance from her parents! So she asks her older brother for $1.00. Being a kind older brother (hardly!), he says that she can have one dollar only if she pays him back with interest. He is charging his kid sister for borrowing some money! Talk about a future banker!

Well, he decides to charger her a common rate of 8%. The sister agrees. She takes her brother’s $1.00 and buys her bubble gum. A couple weeks pass by, and the brother has still received no money. So he approaches his sister and finds out that she just received her $5.00 allowance from Mom and Dad. Big brother comes in, requests his money, and she hands him $1.00. “Nope, nope, nope,” he says. And he reaches down and grabs his eight cents earned from interest. The sister is a bit confused, as she doesn’t even remember what she spent the dollar on. How many times has that happened to someone?! I can remember numerous times of opening up a credit card statement and wondering why the bill is so high! And in this case, the sister no longer has any tangible record of her spent dollar bill. The bubble gum is long gone (a couple weeks ago!), and she owes her brother for something she doesn’t even have any longer.

This story is an easy way to see how interest works. You essentially pay someone for using their money. In this case, the kid sister is paying her brother eight cents for using his dollar bill. Rather than paying for a car or stereo or pack of bubble gum with money, you are actually paying someone for money! That is the principal behind interest. Every day, people pay banks to buy their money. That is interest in a nutshell.

The difference is that it’s not bubble gum that we are buying. And it’s not our brother we are borrowing from. In most cases, the items we purchase are larger and more expensive (clothes, cell phones, cars, motorcycles, electronics, Big Macs, and on and on and on!). And we are usually borrowing from credit card companies or banks.

So “it’s only seven cents,” right? That seven cents on one dollar is the same as $7,000 on $100,000 (7% of $1.00 is $0.07 just as 7% of $100,000 is $7,000.00). But you may argue that you would never charge a $100,000 bill to your credit card. Of course not! You would simply do it another way...as in signing up for a 30-year mortgage on a house with a 7% APR [be sure to see my page entitled “What a House Really Costs You” before making any purchase or to see what it happening after your purchase...you need to see this!]. And I won’t go into the details here, but notice that I said 7% APR...or Annual Percentage Rate. If you bought a house for $100,000, you would certainly NOT only pay $7,000 in interest. In simple terms, you would pay $7,000 in interest in that first year of your mortgage. But check out the above article for the details.

Back to our story about interest...the kid sister actually had to “buy money” from her older brother. She had to pay $1.07 for $1.00. Well, that’s not fair, right?! That depends upon how you look at it. The kid sister had two options: borrow money from her brother and purchase the bubble gum, or not borrow and walk home with no bubble gum. So she could have either not paid for the money and left with nothing or paid for the money and left with what she wanted. She chose to pay for the money.

Now this is a personal matter, and you can read how I feel about it in the article “To Debt or Not to Debt,” but I am not going to tell you what to do. I am not going to tell you that you cannot purchase bubble gum. I am not going to tell you that you cannot purchase a new cell phone. Those decisions are up to you. But I will tell you this: If you purchase a cell phone or a house or a car on credit (with interest), and when I ask you how much you are going to pay for it in the end after all your payments, and you cannot tell me, then hear me on this: I will NEVER support you for your purchase.

Too many times, I see people buying items with their credit cards, or taking advantage of “special offers” (no interest, no money down, no payments for one year!), but they have no idea what they are doing. If I were to ask them how much they paid for that bubble gum, they would tell me $1.00. And that is the wrong answer!!! They would need to tell me $1.07 before their answer would be correct (and before I would be happy). They actually had to pay $1.07 for $1.00 worth of bubble gum.

Interest is simple and quite easy to understand once you know what you are dealing with. Of course,
there are often more details to put into the equation such as APR, different interest rates, compound
interest, revolving interest, interest-free loans (for a time), etc. But as long as you understand even the basics of how interest works, you will be better-equipped in ALL of your purchases.

I used the illustration with bubble gum, but let me put a more realistic scenario here to show the reality of what interest will cost someone...

Let’s say you buy a car for $10,000. You do not have $10,000 in your pocket or in your checking account, so you take out a loan on the car. You get a decent rate of 6% APR over 5 years. After the first year, you will have paid your bank $480 just to use their money. That’s $40/month that is essentially “worthless” to you. It is going straight the big brother (or the bank here). The second year? $360. The third year? $240. The fourth year? $120. And the fifth year? Zero.

So after five years, that $10,000 ended up costing you $12,000. That’s how interest works. You paid the bank $2,000 for the $10,000 they gave to you. You bought their money. That’s free money to the bank, and they love you for it.

As I always tell people, you will see businesses, restaurants, and retail stores go out of business. But when is the last time you saw a bank shut down? And I have always noticed that banks are almost always built out of fine brick and have beautiful landscaping.

Why? Because they can afford to do so.

Why? Because of you and me!

So, as I always say, “Learn one thing, and do something with it.” I want you to figure out how much
interest you pay each month on something. Whether that be your car, your house, your clothes, your cell phone, whatever.

And I want you to find out the exact month that you will pay that off. If I were to ever ask you, when is your house paid off? I want the exact month, year, and how much it will cost you in the end. If I were to ever ask you, when is your car paid off? I want the exact month, year, and how much it will cost you in the end.

Learn one thing, and do something