How to teach kids about compound interest

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How to teach kids about compound interest

Think back to the times in childhood when the basic value of money started to "click" with you.

It might have started with having a toy cash register, or a piggy bank, and realizing that the more money you have, the better it makes you feel. Seeing an older sibling receive money as a gift or an allowance sent the message that obtaining money is important; sometimes it’s rewarded for being special, but sometimes you’ll need to work for it, too.

Growing up, hearing your folks talk about money or seeing them exchange it at the store taught you the lesson that you need to give money to other people in order to get the things you want.

When it comes to learning about interest, though, things can get a bit trickier, and too conceptual, for most kids to understand. The big part about teaching them the value of compounding interest is first teaching them the importance of saving. When you save your money in the bank, it begins to earn money, so the longer you save it for, the more money you’ll have. But you might ask them a more profound question to get them curious: "Would you rather have $1 million now, or, one penny doubled for 30 days in a row?"

Teach them the value of saving over spending

Younger children won’t often grasp the idea that there isn’t an endless, limitless supply of money to spend. Before interest enters the picture, teach your kids the benefit of saving money versus spending it. Once they’re old enough to count, your kids may become exposed to coins and dollars in preschool or kindergarten, learning that each one holds a numerical value. Take this as an opportunity to demonstrate the discipline of holding onto your money versus spending it. If you always spend your money, you’ll have none left. But if you save your money, you can earn more of it just by holding onto it. The ultimate lesson they should take away is that restraint equals reward.

Make it age appropriate

When should you really start teaching kids about compounding interest? Preschool may be a bit too young; but once they start receiving an allowance in the early grade school years and they’re becoming accustomed to the idea of earning and saving money, introducing the idea of interest into the picture then might be the right time. When they’re a bit older (pre-teen age), opening a savings account is the perfect opportunity to teach the power of interest. But be open to explaining interest to them when the opportunity arises. If your son or daughter asks you why we put money in banks, use it as an opportunity to teach about interest, but gauge it by age.

You may tell your kindergarten or grade-school age son or daughter that when you deposit money into the bank, interest is extra money the bank pays you to thank you for keeping it safe. Older preteens and teens may understand a more detailed explanation, i.e. when you deposit money, the bank puts it to work by lending it out. The interest you then receive is a share of those earnings.

Keep it visual and fun

Kids want to be shown, not told or lectured. Turn a lesson on compound interest into a game to keep them engaged and interested. It doesn’t have to be anything too complicated, complex or involved.

"Each year I have a money camp for my two grandchildren," said Marie Phillips of FamilyMoneyValues.com. "Part of that for the past several years has been a compound interest jar. We started with one jar, one dollar, and had the kids calculate and add interest each day for a week. To make it interesting, we use an exceedingly high interest rate (50 percent, usually). At the end of the week, they add up what is in the jar and split the money."

"It’s easy to teach kids about compound interest," noted Tammy Johnston, President/CEO of TheFinancialGuides.com. "You need a stack of change and a teeny bit of patience. Put a dollar on the table and tell them that this is your principal. Then, add a dime. Tell them this is your interest that gets added to your principal."

Johnston says that the point is to continue on as long as you like to illustrate how interest builds on itself. For the older kids, you might write out a chart showing them how much they’re saving, "but having kids of all ages handle and see the actual money helps the lesson sink in much better," Johnston says.

Kevin Cook took a super interactive approach to teaching his children about compound interest.

"I set up a small basket on the driveway (or living room)," Cook, a senior stock strategist, said. "Elevate the basket just enough so they can't look inside. Then, I gave them a roll of quarters and said, ‘Now throw one quarter in and walk a circle around the yard (or house, car, couch, wherever). When you get back here, it's like one month has gone by, and you throw another quarter in until all 40 are in the basket.’"

Cook says parents should participate in the money game to pique their children’s curiosities.

"While they are walking their circle, I throw increasingly more pennies, nickels, and dimes in after each of their quarter tosses," he noted. "The sound of the money hitting the growing pile should raise curiosity. When they see what their nest egg looks like at the end, they are amazed!"

According to Cook, at the end of the game, he compares the pile of savings to another, fictional pile of a person who saved irregularly and didn’t benefit from earning interest. This helps the moral of the game sink in for kids.

You don’t even need to use coins or cash to explain what compound interest is.

"I use candies and a box to teach interest to my nephews," says Russab Ali, founder of SMC Digital Marketing. "I say, ‘Here is one candy. You can eat it now, or put it in the box. In one minute, if you don't take it out, I'll put two candies in there.’ I've just taught them simple interest. Then, after a minute, I tell them, ‘There are two candies in the box. If you wait another minute, I'll give you another candy for every candy in the box. There are two candies, so I'll give you two more.’"

Ali continues this until the candy keeps compounding and growing. "Then," he said, "I explain: ‘The candy is your money. The box is the bank. I am the interest. Since you are leaving your candy in the box, I keep doubling it. When you take it out, you lose out. But remember, you started with one candy, and now you're doubling candies you didn't have!’ That's compound interest."

Lend them money for real

Another exercise is to teach your kids that interest isn’t always earned; sometimes, it needs to be paid. Is there something they’ve wanted to buy, but they don’t have the money for it? You might lend them the money – say, $20 – and create a schedule for them to pay you back $5 over the next four weeks. You might introduce interest into the mix, too, even if it’s a dollar extra a week if the debt goes unpaid. This might cause confusion in a child’s perspective: Why do I need to pay you money when you’re giving me money? You might explain that when you borrow money from the bank, it’s not free money. The bank earns its money by charging you extra for the money you borrow.

Your teen son or daughter may know the basics of borrowing money – that it needs to be repaid – but they may be unaware about how interest works. Think of an example that applies to their life. If they want to save up for a car, but they don’t have enough money to pay for it, they’ll need an auto loan from a lender. The lender doesn’t make any money by letting you borrow $10,000 and repay the same $10,000; by charging you extra money, they make money, which comes at a cost to you. But then, you also get the luxury of driving a car before you’ve paid it off.

Create a payment calendar or chart to map the progress. Start lending them larger amounts to build responsibility. It teaches them about interest, and about trust: I’ll promise to lend you this money if you promise to pay me back. But remind them that a real lender or bank won’t be as forgiving if you refuse to repay the money they lend you.

Let them take control

Once your kids hit their teenage years, it’s time for them to control the balance between earning and paying interest. By now, they should have opened their own bank account in their name; once they begin their first part-time job, they can make deposits and withdrawals on their own. Help them select an account that earns dividends, like a high-interest savings or checking account. Setting aside money in a CD, for example, can remind them to save and not spend – not only will you lose interest if you withdraw from the CD, you may be penalized a fee, too. Working with a real financial institution, with real money from a real job they’ve earned, sets the template for managing their finances into adulthood.

Don’t micromanage their finances; let them develop their own money saving rhythm through trial and error. Help them develop a savings goal and let interest rates work for, not against, them.

The bottom line

Albert Einstein is believed to have said that compound interest is the most powerful force in the universe. While it might not rival the Theory of Relativity, we’re inclined to believe him when it comes to personal financial responsibility. It’s technically never too early to start teaching kids about money to help them grow into financially literate young adults – and teaching them about compound interest, even through simplistic means, can open up a world of awareness and understanding about money, discipline, responsibility and value.