Right up front you need to know that the concept of compound interest is difficult for adults, but get it down and the idea of saving for long-term goals like cars, college, a house or a rainy day becomes, oh, so much easier to get excited about. In fact, whoever came up with this idea was brilliant! (According to Wikipedia, it’s been around since the Romans, but it was Richard Witt's book Arithmeticall Questions, published in 1613, that fully discussed the topic.)
If you can explain and illustrate the power of compound interest to your kids, you are endowing them with the real vision of why saving money is cool; that when they put money away and leave it to its own mischief, it grows!
Back to Wikipedia for the simple description: “Compound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding.” Neat. Now, how do you get your kids geeked up about that? Try this one-week demo:
- On Day 1, have your child “deposit” $1 into an envelope, jar, bag or whatever, and explain that they will be earning interest each day at a rate of 50%. Depending upon the age of your child, you may have them compute how much they would earn each day (duplicating the chart below).
- At the end of each day thereafter, add the “Interest Paid” amount shown on the column below and explain that is the interest earned on their deposit balance from the prior day. Beginning on the third day, they will earn interest on their interest. This is the compounding effect.
- At the end of 7 days, your child will see their $1 grow to $11.39 because of the positive effects of compound interest! Here’s how the daily growth looks:
Deposit Interest Paid Principal + Interest
Day 1 $1.00 $1.00
Day 2 $0.50 $1.50
Day 3 $0.75 $2.25
Day 4 $1.13 $3.38
Day 5 $1.69 $5.06
Day 6 $2.53 $7.59
Day 7 $3.80 $11.39
Total $10.39. In the grown-up world, interest may be compounded daily, monthly or annually, though at rates that are far below 50%. But this illustration shows your kids that the more money they save and the higher the rate of interest they earn, the more money that will be available to achieve their goals. (I’ll talk about risk and return in another blog.)
Using FamilyMint offers the flexibility to pay interest, compounded weekly or monthly and paid annually, on their savings account in an amount that you think would be motivating for your child and comfortable for your budget. This is very similar to how your local credit union or bank handles savings accounts. Get them in the groove early and compounding interest will help them throughout their lives.
Copyright Kids Need to Know about the Wonder of Compound Interest © 2012. All rights reserved