The word Interest has a few definitions depending on context. The reason I bring this up is that two of them apply to this particular Memo at the same time. One definition is – your desire to learn about something or someone. Another definition is – money paid for the use of money lent.
Now, you are either reading this Memo because I have asked you to or (insert bad dad joke) because you have an interest…..get it? In any event, my hope is that you have a desire to learn about people paying you for lending them money.
Okay enough with the dictionary fun! When reading or studying about money you will come across the word Interest quite a bit. In the last memo, I used the example of your dollars being your employees. Those employees worked at a bank and the bank paid them Income for their services which they then gave to you. That Income they earned is called Interest.
As you know, a bank is a place where some people keep the money they earn. It is safe there and the government guarantees that it cannot be stolen. If it is stolen, the government will give you your money back. Pretty sweet right?
Now if a bank just collected and stored everyone’s money and then paid them Interest to keep it there, what would happen? That is right, the bank would go out of business because they would be paying people to keep their money in the bank but would not be earning any money themselves. A bank is a business and businesses have to make money. So how do they do it?
Well, Interest of course.
One of the main ways banks earn Interest is by lending other people your money. In exchange for lending someone your money, what do you think they do? That’s right, the bank charges Interest. Now, the Interest they charge someone to borrow money is higher than the Interest they pay you for keeping your money in the bank. The difference between the two is how the bank makes money. Here is an example:
- In the last Memo, the scenario was that you put $50 in the bank for a year. At the end of that year, the bank paid you Interest for keeping it there. Let’s say it was $5.
- The amount of Interest a bank pays you on your money is expressed as a percentage and is called the Rate or Interest Rate.
- Let’s say that the Interest Rate they pay you is 10%. What is 10% of $50 . Yeppers…$5…is the amount the bank pays you to keep your money with them.
- So now if someone wants to borrow money from the bank, they are going to have to pay more than the 10% the bank is paying you in order for the bank to make money and stay in business.
- Okay now, let’s say there is a girl named Sally who wants to buy a pair of boots for $50 but she does not have the money saved as you do. One of the ways she could get the boots without having the money is to go to the bank and borrow the $50. Of course, she would have to pay the bank 20% Interest to do so. This is why borrowing money is not a good idea….IT’S EXPENSIVE!
- At the end of the year, the bank gets back the $50 plus $10 (20%) in Interest from Sally. They pay you the $5 they owe you and keep the other $5 for themselves. BOOM….they just made $5 by loaning your money to someone else and paid you $5 for letting them do it. I know…….MIND BLOWN!!
Now let me ask you a question. Would you rather be the person lending the money or the person borrowing the money? Think of it another way, would you rather get paid for someone using your money, or have to pay to use someone else’s? Pretty INTERESTING huh? Sorry, I couldn’t resist!