Interest Rates: The Price of Using Someone Else's Money

What this means

You already understand prices. A price tells you what you give up to get something. A movie ticket has a price. A pair of shoes has a price.

Money has a price too, but only when you are using somebody else's money for a while. That price is called interestThe price paid for the use of borrowed or saved money, usually written as a percentage of the amount per year., and the percentage that sets it is the interest rateInterest expressed as a percent of the amount borrowed or saved per year..

Here is the part that surprises people: it is the same price on both sides. When you put money in a savings account, you are the one lending. The bank uses your money, and it pays you interest for that use. When you take out a car loan, you are the one borrowing, and now you pay interest for the use of the bank's money. One price, two directions.

Why should anybody charge for this at all? Three reasons, and they all come from the lender's side of the deal. First, opportunity costThe value of the next best thing a lender gives up by lending money instead of using it another way.: money handed to you is money the lender cannot spend or lend to anyone else during that time. Second, risk: you might not pay it back, and the lender absorbs that possibility. Third, waiting: most people would rather have money now than the same amount much later, so they need to be paid something to wait.

Suppose you borrow a hypothetical 500 dollars at an interest rate of 6 percent for one year. Six percent of 500 is 30, so you would repay 530 dollars. The extra 30 dollars is not a fee for paperwork. It is the price of having had 500 dollars for a year that were not yours.

Why it matters

Almost every big money decision you will ever make runs through an interest rate. Buying a car, paying for college, carrying a balance on a credit card, opening a savings account for a goal. The rate quietly decides how much that decision actually costs or earns.

It also matters that the rate changes your behavior, not just your total. When rates rise, saving pays better, so people tend to save more. At that same moment borrowing costs more, so people tend to borrow less, or borrow smaller amounts, or wait. That is exactly how a price is supposed to work.

Try it

1. Look up two real numbers today and write them down with the date. First, the interest rate a bank or credit union near you advertises on a savings account. Second, the interest rate advertised on a credit card or a car loan.
2. Label each one. For which rate are you the lender? For which are you the borrower? Write one sentence explaining who is paying whom in each case.
3. Take a hypothetical 1,000 dollars in savings. Using the savings rate you found, calculate what you would earn in one year. Then calculate what you would earn if the rate were three times as high. Write down the difference.
4. Now imagine you are saving up for something specific that costs 1,000 dollars. Under which of those two rates would you be more willing to leave your money in the account instead of spending it? Say why in your own words.
5. Take a hypothetical 1,000 dollar loan. Using the borrowing rate you found, calculate the interest for one year. Then triple the rate and calculate again.
6. Answer honestly: at the tripled borrowing rate, would you still take the loan? Would you borrow less? Would you wait? Write two or three sentences.
7. Fill in the pattern you just discovered: "When the interest rate goes up, people tend to save ______ and borrow ______." Then explain why the same change pushes those two behaviors in opposite directions.
8. Write a short answer to a younger student who asks: "Why does the bank get to charge extra? I am paying it all back anyway." Use at least two of the three reasons from this lesson.

Check yourself