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Learning that borrowing money isn't free and understanding how loan interest works.
Imagine you want a brand-new bike that costs 50. A bank says they will give you the money today, but you'll end up paying them back 30$ go, and why does it exist?
When you borrow money from a bank, you aren't just getting a free favor. You are using the bank's money to buy something now instead of waiting until you've saved up. Because the bank is taking a risk (you might not pay them back) and they are providing a service, they charge a fee. This fee is called interest. Think of interest as 'rent' for money. Just like you pay rent to live in an apartment you don't own, you pay interest to use money you haven't earned yet.
Quick Check
In your own words, why is interest often called 'rent for money'?
Answer
Because you are paying a fee to use something (money) that belongs to someone else (the bank) for a period of time.
When you take out a loan, the original amount you borrow is called the principal. The extra money you pay back is the interest. To find the total amount you actually spent on an item, you must add these two together.
This means that buying something with a loan is always more expensive than buying it with cash. If you buy a game for $\$50\. If you borrow the money and pay $\$5\!
Sarah wants a tablet that costs $\$100\ in interest to borrow the money for one year.
1. Identify the Principal: $\$100\
3. Calculate the Total Cost: $\$100 + \$15 = \$115\ more than the sticker price because she used a loan.
Quick Check
If a loan has a principal of and the interest is , what is the total cost?
Answer
The total cost is .
Not all loans cost the same. Two main factors change the price: the interest rate and time. The interest rate is usually a percentage, like . A higher percentage means a higher cost. Time is also critical. The longer you take to pay the bank back, the more interest you will owe. This is because you are 'renting' the money for a longer period. To save money, borrowers try to find the lowest interest rates and pay the money back as fast as possible.
Imagine you borrow $\$1,000$ to buy a used scooter. You have two choices for your loan:
1. Option A: Pay back in 1 year. Total interest = $\$50\.
Even though the monthly payments might be smaller for Option B, the Total Cost for Option B is $\$1,150\. Waiting longer to pay costs you an extra $\$100$!
A business borrows $\$2,000$. They are offered two different interest rates for a 1-year loan:
* Bank 1: interest rate. To find the interest, calculate $0.10 \times 2000 = \$2005\%0.05 \times 2000 = \.
By choosing the lower interest rate, the business saves $\$100\, while at Bank 2 it is only $\$2,100$.
What is the 'Principal' of a loan?
If you want to pay the LEAST amount of interest possible, which loan should you choose?
True or False: Buying an item with a loan is cheaper than buying it with cash.
Review Tomorrow
Tomorrow, try to explain to a friend or family member why a 1,000 to pay back.
Practice Activity
Look at an advertisement for a car or a large appliance. Look for the 'cash price' versus the 'monthly payment' and see if you can find the total cost if you paid it off over 3 years.