One of the most valuable financial lessons you can share with your kids before they leave the nest is to explain what interest rates are and how they work. The important financial transactions they'll conduct as adults will likely be affected in some way by interest rates, whether as a lender or a borrower.
Here's some background information to help guide those conversations:
Interest rates for lenders. Anyone who has a savings account or owns government or business bonds is, in effect, lending money to those institutions and earning interest on the loan. Unless you buy tax-free municipal bonds, however, this interest income is probably taxable, so shop around for favorable rates to maximize your earnings and help offset inflation. Compare bank CD, savings and checking account interest rates at www.bankrate.com.
Interest rates for borrowers. Interest rates have even more impact on you as a borrower, especially for large purchases. For example: Most mortgages are for 15 to 30 years, so reducing the interest rate by a point or two could save tens or hundreds of thousands of dollars over the life of the loan. And credit card rates may vary by 10 points or more, depending on your credit rating.
Most borrower interest rates are expressed in terms of annual percentage rate (APR). With credit cards, the issuer may charge a fixed APR, or change it as bank interest rates vary ("variable rate"). Each billing period, the company charges a fraction of the annual rate, called the "periodic rate," on outstanding balances. With mortgages, the APR also factors in points, origination fees, mortgage insurance premiums and other fees.
Interest rates may also depend on:
- Whether the loan is "secured" (secured by collateral such as a house or car) or "unsecured" (not tied to collateral – like credit cards – so the lender relies on your promise to pay it back). Because they're riskier for the lender, unsecured loans typically have higher interest rates.
- Credit score – people with higher credit scores are deemed less risky and therefore get much more favorable rates.
- Term length – long-term loan rates are usually higher than short-term rates, because the longer the loan, the greater the risk to the lender that you might default.
Fixed vs. adjustable. Home mortgage interest rates are either fixed for the life of the loan, or adjustable at predetermined intervals for part or all of the loan period. They're usually tied to an index such as the 10-Year Treasury Note. When rate indexes are relatively high, many opt for an adjustable rate mortgage (ARM), which typically has a lower beginning rate and is therefore more affordable initially. However, when rates climb due to inflation or other factors, monthly ARM payments can rise sharply, which is why many people prefer the more dependable fixed rate.
Bottom line: Many factors in setting interest rates are beyond our individual control; however, teach your kids that they can control their own credit score, which can have a tremendous impact – good or bad – on interest rates.
Many good resources teach how to protect – or repair – your credit score, including MyFICO.com's Credit Education Center (www.myfico.com/CreditEducation) and What's My Score (www.whatsmyscore.org), a financial literacy program run by, Visa Inc.