Okay, I'm gonna give it to you straight: an interest rate is a way to make money! And that's a good and a bad thing! What? Lemme show you!

     Let's say you had 10 dollars, and a friend of yours wanted to borrow 5 of it just for a couple of days until he got his allowance. Now, being good friends you'd probably lend it to him without any strings attached, but that doesn't happen in this story. Lending him the 5 dollars is an opportunity for you to make some money. How? Okay, you tell your friend that you'll let him borrow the money for a couple of days as long as he pays you back on time and gives you an extra dollar. When he pays you back, you now have 6 dollars instead of 5! You just made money from your own interest rate! And a pretty hefty one at that - 20%! We'll figure that out later.

Now or Later

     Why would your friend agree to such a deal, is he short a couple straws in the ol' haystack? Well, maybe, but people borrow money like this all the time and for many different reasons. Look at this example: a house usually costs about $150,000. Let's say your parents earn $40,000 a year, and after expenses (like food, medicine, you *yes you!*) they save $5,000 a year. To buy a house, they would have to save up for 30 YEARS before you would ever have a roof over your head! How did they get around that, you live in a house now! Well, your parents borrowed the money, and chances are they're paying the money back with interest! So you see, sometimes you have to borrow money to get something you need now rather than wait until you have all of the money later.

     Let's go back to you and your friend. He paid you 6 dollars for borrowing 5, right? An extra dollar. 1 out of 5 is the same as 2 out of 10 isn't it? And 2 out of 10 is the same as 20 out of 100, which gives us our percentage (%=out of 100) of the interest = 20%! That's pretty good!

Banks and Interest

     When you talk about interest rates and banks, you're usually talking about the good interest, which means that the bank is paying you interest for the money that you have deposited with them. That's good because it means that you're making money, just like you were if you had lended your friend the 5 dollars.

Credit Cards and Interest

     Okay, so your friend who paid you back 6 dollars for borrowing 5 didn't earn money, did he? That's what happens when you borrow money, and that's what credit cards are: borrowed money! Every time you use a credit card, you end up having to pay back a little bit more money than the amount you borrowed (this goes for loans too). It gets hairier. If your credit rating isn't as good, you have to pay more in interest back! Let's go back to our example: let's say you lent money out to multiple friends at the same time, some good friends and some not-so-good. Would you charge the same dollar to lend the money to the not-so-good friends as you did your good friends? Probably not, you'd most likely charge more just in case one of the not-so-good friends didn't pay you back, so you'd still make money. This is exactly how credit cards and loans work! I've gone way over on this one, so look for my explanation on credit ratings next week!

Did You Know?

Interest rates are nothing new. In fact, some of the earliest of ancient writings found in Mesopotamia are nothing but bank records containing, among other things, interest rates and payments!