THE BLOG
06/13/2011 03:10 pm ET Updated Aug 13, 2011

Teach Your Kids About Interest Rates

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 that can help you 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.

Savings and interest-bearing checking accounts typically offer low rates and often charge fees for not maintaining minimum balances. You may do better by putting your money into a money-market deposit account or certificates of deposit. Compare bank CD, savings and checking account interest rates at Bankrate.com. To find credit unions for which you're eligible, visit Credit Union National Association.

Interest rates for borrowers. Interest rates have even more impact on you as a borrower, especially for large purchases. For example, most home 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. Credit card rates may vary by 10 points or more, depending on your credit rating.

Practical Money Skills for Life, a free personal financial management site run by my employer, Visa Inc., contains handy calculators that can help you compare total mortgage payments under different interest rates, as well as compare credit card balance payoff scenarios under different interest rates.

Most borrower interest rates are expressed in terms of an 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.

Two key interest rates affect the rate you'll get from your bank or other lender:
  • Discount rate: The rate the Federal Reserve Bank (the Fed) charges banks for short-term loans. In a sluggish economy (like now), the Fed often lowers the discount rate to spur lower interest rates for borrowers, thereby boosting the economy.
  • Prime rate: The rate banks charge their commercial customers with high credit ratings for short-term loans. Interest rates for credit cards and home equity loans/lines of credit are often tied to the prime rate (for example, "prime plus 5 percent.")
Your interest rate may also depend on several other factors, including:
  • 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.
  • Your credit score -- people with higher credit scores are deemed less risky and therefore are charged 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.
  • Quality of asset being financed -- houses tend to increase in value over time compared to cars, which typically lose value; thus, mortgage rates are often lower than car loan rates.
  • New credit cards often come with an introductory (teaser) rate, which may increase after at least six months have passed if terms are clearly disclosed.
Fixed vs. adjustable. 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 tied to an index such as the 10-Year Treasury Note. When rate indexes are relatively high, some people opt for an adjustable rate mortgage (ARM), which typically charges a lower initial rate. However, when rates climb due to inflation or other factors, monthly ARM payments can increase sharply, which is why many people prefer the more dependable fixed rate.

It pays to think of yourself as both a lender and a borrower. Remember, if you're earning 1 percent on savings but shelling out 18 percent on credit card balances, you're actually losing 17 percent -- plus paying taxes on the earnings.

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.

There are many good resources for learning more about what you can do to protect or repair your credit scores, including MyFICO.com's Credit Education Center, the Federal Trade Commission's Credit & Loans Page, and What's My Score, a financial literacy program run by my employer, Visa Inc., which also features a free FICO Score Estimator that can help you approximate your score.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial adviser for specific information on how certain laws apply to you and about your individual financial situation.

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