Simple ways to teach kids about compound interest
By Aaron Crowe
Teaching your children to be empathetic, how to share, clean up their toys and other skills and habits can be some of the most rewarding, and difficult, parts of being a parent. Add in financial lessons, such as compound interest, and you’ve got your hands full.
Ask any parent who has helped a child with math homework, and they’re likely to tell you how daunting it is and how the sessions can lead to tears. And it can only get more difficult with age.
For parents who are financially savvy, or at least want to be, there are some financial lessons that they can teach their kids that go beyond the basics of setting up an allowance or teaching delayed gratification by not buying them every toy they want. Learning the ins and outs of compound interest may sound boring, but it’s an important lesson that can be fun that you may wish you had learned when you were young to help avoid financial pitfalls.
The benefits of learning how compound interest works are enormous. It can help to understand the downside to having credit card debt, such as how long it takes to pay off interest charges, and explain the upside of contributing regularly to a retirement program or paying off a mortgage early.
Here are a few ways that parents can teach their children about compound interest:
Compound interest with real money
Denise Winston, a 25-year former banker and financial book author, suggests teaching about compound interest by using two $100 bills and asking the child to place or hide them somewhere. Ask them: If we come back in six months or a year will the money still be there?
What could happen to it? Could you lose it, forget where you put it? Could it get stolen? Could you spend it? Could it burn in a fire?
If it’s still there, did it magically make more money? Nope!
But if you put in a bank, in the right account with the right protection and interest rate, it will multiply. When you put your money in the right account and put it to work it becomes your employee. It works so you don’t have to.
This can also be taught, Winston says, by opening a bank account and using the bank statements to prove the point. Or better, use the visual aid of cash.
Future value tables, Rule of 72
Compounding interest can also be explained with future value tables, says Ken Boyd, an accounting author from St. Louis.
Compounding simply means earning interest on interest. “If you earn interest on a bigger amount — your beginning principal amount plus interest — your earnings grow at a faster rate,” Boyd says.
Computers and calculators have made future value tables almost obsolete, but he sees them as a great way to visually understand the idea of compound interest.
Using a value table of $1, the interest rates are across the top, and the time periods run along the vertical axis. Investing $1 at a compounding rate of 5% becomes 1.276 at the end of five years. A dollar grows to $1.61 at 10% interest for five years, showing how quickly a dollar can grow as the interest rate increases.
Another tool is the Rule of 72, which says that given a particular rate of interest, you can find out how long it takes for your money to double. Investing money at 8% will double your money in nine years: 72 divided by 8 equals 9.
Compound interest with a piggy bank
Maybe the easiest way to teach a kid about compound interest is to set up a bank account at your home with a mason jar or piggy bank, says David Bakke, a financial expert at Money Crashers who started teaching his son about money when the boy was 4.
“Ask your kid to put a dollar in it and when he or she does, add five cents of your own,” Bakke says of the home piggy bank. “This creates an interest rate of 5%. You might not want to go higher than that so your child doesn’t get an unrealistic expectation of what he or she will receive in the real world.”
He also recommends keeping track of the account balance on a sheet of paper, and using a calculator. Every time your child makes a deposit, calculate 5% of the balance and add that in, rounded to the nearest penny. Show them the balance at the end of each week or month to illustrate the power of compound interest.
Your kids don’t have a credit card yet, but when they do and hopefully remember to stay out of debt, they’ll have you to thank for this lesson. It’s a life-long lesson every parent should teach.
Read the original story at The Credit Solution Program.