Einstein famously said that compound interest is the most powerful force in the universe – you can teach your child to harness its powers.
You may have read the headline and tuned out immediately. But here’s the secret: you don’t have to be a rich parent to raise a rich kid.
It doesn’t hurt to have a few million tucked away in investments, but the wealthiest parent can raise a child doomed to financial failure if they don’t school their child on the importance of compound interest. And a financially-challenged parent who has made mistakes can set their child on the path to financial freedom if they instil sound financial practices from an early age.
And if compound interest is still a mystery to you, read on.
It’s simple, really.
It’s money earning interest, that interest earning interest, and so on. That can work for you, with the principle of saving, or against when you use a credit card or hire purchase.
That may sound difficult to explain to a child. But it’s basically all about how time affects money’s value.
First, explain what interest is
As adults, we take interest for granted. Keep the explanation simple for kids: interest is what a bank pays you to keep your money there. The longer the money stays in the bank, the more money you make.
The dark side of compound interest
Of course, you’ll also want to talk about the other aspect of interest: paying it.
When bills aren’t paid on time, interest accumulates — only instead of earning more money, they’ll owe more. They’ll be paying interest on interest, instead of earning interest on interest. This explanation is especially important as kids get older and approach the age they might get their first credit card.
You can demonstrate the principles of compound interest from a young age.
1: The marshmallow test
Give your child one marshmallow and tell them if they don’t eat it today, they’ll get another one tomorrow. Tomorrow, they’ll have two, and if they put them aside, they’ll have four the next day.
This can be a good, tangible lesson about how delaying gratification can increase something’s value.
2: The bank of Mum and Dad
When they’re a little older, start a money jar with coins. Get them to deposit one coin and match their deposit with a smaller coin of your own, as interest. As the amount of coins they deposit goes up, so does the interest. But if they withdraw coins from the jar, the interest goes down too.
3: The cost of a loan
Lend them $5, and charge them 10% interest each week until they pay it back. If they pay it back within a week, it’s just $5. If it’s two weeks, they owe you $5.50. If it’s three weeks, then it’s $6.05 and so forth. This demonstrates how loans result in you paying interest on interest.
4: Create a visual
Is there a toy or gift your child really wants? Make a deal: Tell them if they save a certain amount of money, you’ll buy it. Establish at the beginning how much interest they’ll earn on their savings, such as 5% or 10%. Draw up a savings goal chart and put it on the wall. At the end of each week, mark their progress. Write down how much they have saved, as well as how much interest they’ve earned. They’ll be able to see over a month or more the power of compound interest.
Want more on finance? Check out familytimes.co.nz/kids-running-summer-businesses
