Interest rates affect many of Americans’ financial moves, yet you might not really know how they work. You’re probably most familiar with interest rates as the figure that makes your credit card bills and loans cost more money over time, but it’s a bit more complex than that.
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To help clarify exactly how they work and what you need to know, I asked ChatGPT to help me understand how interest rates work as though I were 12 years old. The AI tool is good at breaking down complex details into simpler parts, and that’s just what it did.
Twelve-year-olds love candy, so what better way to explain money than by breaking it down in sweet terms?
According to ChatGPT, an interest rate is just the price of money. “Just like a candy bar has a price tag, borrowing money comes with a cost — and that cost is interest, usually shown as a percentage,” it explained.
So, for example, if your “candy bar” is $100 that you borrow from the bank, and the interest you must pay in the time it takes you to return that money is 5% per year, after one year, you have to pay back $105.
“That extra $5 is the interest — the price for using their money,” ChatGPT said.
That original $100 you borrowed? That’s called the “principal.” You can think of it as the starting amount or main chunk of money. “Interest is always calculated based on that principal, and sometimes even on the interest that adds up over time, ChatGPT said.
Or, to have more fun with it, ChatGPT said, “Think of it like the base of a pizza. Everything else (like interest) gets added on top of it.”
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Why do we even have interest rates? ChatGPT said it’s because “time is valuable.” More to the point, “When someone lends money (like a bank), they’re giving up the chance to use that money right now.”
So, interest is the fee you pay for the opportunity to use someone else’s money, which also happens to be a great business strategy for those who have the money to offer.
If so far interest has sounded pretty basic, it now gets just a tiny bit more complex, because there’s not just one kind of interest, but two.
This type of interest is where you only pay interest on the original amount you borrowed.
Example: You borrow $100 at 5% for 3 years = $5 x 3 = $15 interest. Add that to the original $100 you borrowed, and you pay back $115
