Tiny MBA #9: Interest Rates And Escalators

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Welcome to today’s Tiny MBA topic: interest rates.

Definition: Interest Rates

Interest rates are the cost of borrowing money. When you borrow money, you usually must pay the lender a certain percentage of the loan amount each year as interest.

A simple way to understand interest rates:

Interest rates and loans are complicated, but you can think of them like trying to walk up a down escalator.

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Illustration by Madeleine Kelly

When you borrow money – say a student loan, or a mortgage to buy a house, or to start a business – you’re starting at the bottom of that escalator and have to get to the top.

The higher the interest rate, the faster the down escalator is going. The bigger the loan (amount of money you borrowed), the heavier a backpack you’re carrying on your back.

There are many loan situations that can difficult, as the down escalator analogy shows:

If you have a small loan (light backpack) with a high interest rate (fast escalator), you’ll have to run pretty hard to get to the top of the very fast down escalator.

If you have a big loan (heavy backpack) and a low interest rate (slow escalator), you’ll still struggle to get to the top.

But the worst case is a big loan (heavy backpack) and high interest rate (fast escalator). Many borrowers in this situation, whether individuals or businesses, never make it to the top.  In other words, they can’t ever pay back their loan.

The easiest way to avoid this down escalator problem is to avoid borrowing money, or if you must, keep your borrowing small (light backpack) and with the lowest interest rate possible (slow escalator).

Saving money is the best way not to have to borrow it. And if you do borrow, try to pay the loan back as quickly as possible (spend as little time as possible fighting the escalator).

Tiny MBA is my occasional series of short stories illustrating business concepts for kids.

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