Teach Kids About Compound Interest

If you have a child who is old enough to do basic math, then teaching them about why compounding interest is important for them is a great idea. A topic like this can be difficult to understand without seeing it in action. You can use the penny method to teach your children about how interest works, and the dollar method to demonstrate compound interest. Take time to understand compound interest and why it is important.

Steps

Helping Your Child Understand What Interest Is

1. Begin by giving your child a dollar. Get a dollar bill and give it to your child. Explain that you are going to teach them about something called interest.
   • Understand that this method doesn’t demonstrate compound interest. The point of this method is to show kids what interest is. Show this to your child first if they are struggling to understand interest.
2. Write them a receipt for the “deposit.” Explain that you are the "bank" and that they can earn more money if they give you the dollar back to hold. Make sure to explain that they will get their dollar back, along with more money, when the game is over. To make your point, give them a "receipt" showing their deposit and current balance ($1.00).
   • Explain to them that it is important to keep these receipts in a safe place so that they have proof that they have put that money into the “bank.”
3. Give them a penny for interest each day. Explain to your child that they will earn a penny for each day you let them hold their dollar. When you deposit a penny, place it in a container that is their “bank account.”
   • If your child doesn’t know about how banks work, be sure to explain what a bank is. Explain that a bank is a place where you can keep your money safe, and that when you put your money in the bank you are agreeing to let the bank use your money, but it will all be there when you need it.
4. Show them how much money they have accrued. Explain how to find out how much money is in their bank account. In this case, explain that all they have to do is ask you. At the end of one week (or however many weeks you want to do this demonstration), ask your child to check their balance. Ask them to check their receipts to figure out how much money they have put into the bank. When they do this, then dump out the pennies, and ask them to count the pennies. Explain that the extra pennies are interest that they've earned.
   • Explain that the original seven pennies have grown to eleven pennies (assuming you added one penny every other day) because the bank paid a penny of it’s own into the account as a thank you for allowing them to use your child’s money.
5. Illustrate the effects of spending. Ask the child to withdraw some money from the bank account. Demonstrate that this means reducing their balance, meaning that they now have less money in the account. Give them a new receipt showing the balance after the withdrawal.

Teaching the Concept of Compound Interest

1. Set up three jars. Compound interest can be thought of as three amounts: the principal, the interest, and the interest earned on interest. Set up three labeled jars to represent the different amounts.
2. Put one dollar in the "principal" jar. Add $1.00 to the jar, and explain that you will help them to add 10% interest on what is in the jar to the "interest" jar each day. You will also need a way to keep track of how much money is in each jar and the total amount between them as you add money.
   • You can do this for longer if you want. A week should be enough time to show your child how compound interest works.
   • Keeping the jar in a place where it is in view will keep you both from forgetting about the project.
3. Add 10% interest to the contents of the first two jars each day. On the first day, you will have $1.00 in the jar, so for the second day, ask your child to help you figure out what 10% of $1.00 is. Once they tell you that 10% of $1.00 is 10 cents, add a dime to the interest jar. Ask them to tell you what the new total is. Keeping the interest figure low will present a more realistic idea of what your child could expect to earn from a bank. If you want to, you can also use higher interest rates.
4. Add to the interest in the interest jar. Have your child add another dime to the interest jar on the third day. Then, explain to them that 10 percent of the money in the interest jar must be added to the interest on interest jar. Allow them to calculate that this would be 1 cent and add a penny to the interest on interest jar.
   • On each of the following days you will repeat this process. Have your child count the contents of the jar, and ask them to help you calculate 10% of the total contents of the first two jars.
   • Remember to total the amount you have on each day. For example, on the third day you now have $1.21.
   • On the fourth day, you would add another dime to interest and then calculate that 10 percent of the interest jar is now 2 cents. You can then add 2 pennies to interest on interest for a total of $1.33.
5. Help your child add up the new total. On the eighth day, you and your child can now take down the jar and count up the new total. Be sure to point out that your child has saved up almost 100% of what they put in the jar in the first place. Remind then that only the dollar represents money that they paid in to the "bank."
   • Explain to your child that this is a good way to grow their money.

Explaining Compound Interest Further

1. Explain why banks might pay compound interest. When thinking about why a bank should give you money when they are the ones keeping track of your money for you, it is important to remember that you are giving the bank a loan. When you deposit money into the bank the bank is then using your money for its own purposes. Thus, they pay interest to you as a way of thanking you for the loan.
   • Usually, the bank uses your money to make loans to other bank customers. The bank makes money on this by charging higher interest fees on the loans than what they are paying you in interest.
   • Accounts with compound interest are especially beneficial when you're young, because the more years you have to compound that interest or growth, the larger your account's going to be in the long run.
2. Talk about what makes compound interest especially valuable. Not all accounts will offer compound interest specifically. Compound interest is a great thing because not only does it pay interest on what you put in the account (this is called the principal), it also pays interest on the interest it paid you last time.
   • This makes your money grow faster than if they just paid you interest on the amount you put in the bank and left the extra interest money out of the equation.
   • Explain that each year, you're going to be building on top of the growth for the previous year. If you start with $100 and it grows by $5, the next year you'll have $105 to grow.
3. Help children understand why they should care about compound interest. In the society we live in, it’s important for children to learn why it’s important to save money, and how they can do it most effectively. If you give your children an allowance, teaching them to save part of that allowance rather than running to the store to blow it all at once can create good spending habits that will follow them throughout their life.
   • When teaching children about compound interest, make sure that you begin the discussion by talking about what interest is in the first place.
   • For example, you can say something like, “When you have a bank account, they do their best to keep your money safe. At the same time, though, they take your money and lend it to other people who need it. As a way of saying thank you, banks usually pay you a little bit of money. This is usually a percentage, say 5%. They pay you 5% of whatever you’ve got in your account. So if you have $500 dollars, they pay you an extra $25 just because they appreciate you keeping your money with them.”
   • Talk to kids early about things like the value of a dollar and how savings and investments work. If you don't know about these things, get somebody else to help, whether that's talking to a financial planner or enrolling them in a finance or economy class, just to get the conversation started.

Tips

• Teaching kids the importance of good spending habits early on will help them manage their money when they get older.

Warnings

• While it may be good to use very high-interest rates for demonstration purposes, be sure to explain that banks usually offer much lower rates. It is still good to take advantage of compound interest, but be realistic about what they can expect.

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