Financial Literacy

Sample Lesson - Introduction

Lesson 1.05: Exponential Money

"My interest rates are low! Only one dead squirrel a month for the first year!"
(Source)

Here's what our boy Adam Smith said a couple hundred years ago:

"Man is an animal that makes bargains: no other animal does this—no dog exchanges bones with another."

It's true. We're just as smelly and hairy as other animals, and we're just as distracted by shiny things (Ooh, another Transformers movie?!), but our business is way, way more complicated.

For example: interest. As you know, interest is the fee that somebody pays when they borrow money. Rather than paying a fixed fee (like $50 to borrow $2,000), they pay a percentage of the borrowed money.

"Until you pay me back, you owe me an extra 1% of your debt, every month." That 1% fee is the interest.

Interest is more complicated than a fixed fee, but it's also more fair. If one dude borrows $2,000 for a month, and another dude borrows $2,000 for 5 years, why should they pay the same fee?

You earn interest when you put money in the bank, too. Why? You're actually lending the bank your money. They need to pay you interest as a little "thank you" for not believing crazy YouTube conspiracy videos and storing your cash in a coffee can under the bed.

We're just reviewing right now. You (should) know all this stuff. But today, interest is going to get even more complex. We're gonna talk about compound interest.

Basically, compound interest is interest that compounds every year (or every month). Your interest earns more interest as time goes on.

Confused? No worries: you'll be wheeling and dealing before you know it.

Sample Lesson - Reading

Reading 1.1.05: Quarter Compounder with Cheese

So, when you pay back a loan, you have to pay back the full borrowed amount plus a little extra. That extra tidbit is the interest.

The same thing is true when you put your money in an investment account: technically, you're loaning your money to the investor, so they owe you straight cash, homie. But did you know you can make interest off your interest?

It's true. Your mind = blown. We'll go through an example really slowly so you can see what we mean.

Let's say you put $100 in a savings account, and let's say you're earning 10% interest a year—wishful thinking, yeah, but it's an easy number, so just go with it. At the end of the year, how much interest have you earned? Well, 10% of 100 is 10:

$100
x .10
$10

Aren't you glad we used an easy number? So, you made $10. Now you've got $110.

If you leave all that money in the bank for another year—instead of feeding your Chipotle burrito habit—you'll earn 10% of $110, not just 10% of $100. Now you've earned $11 of interest. Your interest just earned interest. It compounded. That means even more burritos for you: you've got $121.

We've just shown you how compound interest works. Basically, in the second year, you're not just loaning the original $100: you're also loaning your $10 of interest from the first year, too.

Why should you care? That's an "easy mode" question: most investment accounts offer compounding interest. You won't have any idea how much money you can earn unless you know how interest compounds.

We want to make you get this idea down pat, so check out our video for a deeper explanation:

Now that you know what compound interest is, let's take a look at the math.

Basic Interest Formula

I = Prt

Not bad, right?

I is the amount of interest you're going to earn.
• P is the original amount of money you put in the account.
• r is the interest rate.
• t is the number of times you're generating interest.

Remember our first example? $100 at 10% interest a year, for one year? It looks like this in math mode:

I = Prt
I = ($100)(.1)(1)
I = $10

Totally easy. Compound interest is more complex, so its formula is scarier-looking. Don't bug out:

Compound Interest Formula

Wait, come back! We can explain!

• A is the total amount you'll have in your account when it's all over. This is the number we're solving for.
• P is the amount you originally placed in the account. If you started off with $500, P = 500.
• r is the percentage of interest you're expected to earn—in real life, you'd want this to be something crazy high, like 40%, but anything "guaranteed" higher than 3% or 4% is a 100% scam.
• n is the number of times per year that your interest "compounds," i.e. when it starts generating its own interest. Some accounts compound once a year—easy math for the win—but some compound two or four times. In those cases, n would equal 2 or 4.
• t is the total number of years.

So, the formula looks terrifying, but it's easy to use. You just plug in the numbers and then do some basic math. You don't have to add imaginary numbers or divide by zero or anything.

Just put the numbers in the formula and put your calculator to work. We'll practice later in the lesson.

For now, just remember that compound interest is a kinda-frightening-but-actually-easy formula that tells you how much money your investments are going to earn in the future.

Sample Lesson - Activity

Activity 1.05a: Checking In

Are you following along so far? Are you ready to take Wall Street by storm? Prove it. Take a stroll through the questions below:

Sample Lesson - Activity

Activity 1.05b: Math Intensifies

Quick math question: If you put $5,000 in a savings account that promises 1% interest every year, how much interest will you earn after 6 years?

1% of $5,000 is $50, and $50 x 6 = $300. Right?

Nope. Because interest compounds during that time. You're not getting 1% of $5,000 every year. You're getting 1% of $5,000 the first year, then 1% of $5,050 the second year…you see where this is going?

The good news? You're making more money than you thought. The bad news? The math is a little more complicated. It's time whip out the nightmare formula from earlier:

When we plug in the numbers, it looks like this:

A = 5,000(1 + .01)⁶

After we do the math, A = 5,307.60. So, you didn't make $300 over those six years. You made $307.60. That's a whole extra burrito.

(Seriously, you should refresh yourself on the Order of Operations if you need help knowing which math operation to do first—in this case, parentheses first, then exponents, then multiplication.)

Now it's your turn. For each of the following questions, you'll have to use the compound interest formula: