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Teaching Children About Compound Interest
One of the ideas that I’ve really been struggling with in terms of teaching my kids about money is the power of compound interest.
They understand the value of not spending money and saving it for the future. They’re able to set big savings goals for themselves and not touch allowance or birthday money for months to achieve that goal.
They’re pretty good at understanding that it’s usually beneficial to hold onto your money until something really good comes along rather than just buying the first cool thing they see. The willpower part isn’t hard.
They even understand that if you put money in a bank or use it to buy something valuable, your money will grow while you save it.
Where things get tricky is with the idea of compound interest. This has been something I’ve struggled to illustrate for a long time.
A few months ago, however, a reader named Jeremy sent me an idea:
Here’s what I did with my kids for two months last year. On the first day of March, I put ten pennies in a bowl. I said, every day this is going to earn 10% interest which means that for every 10 pennies in this bowl, I’m going to add another penny. On the last day of April, we’ll spend it together doing something fun. How much do you think will be in the bowl?
There were 61 days between March 1 and April 30. I encouraged them to guess and they came up with guesses on the order of $1 or maybe $2. My oldest kid was actually pretty unimpressed.
So, each day at breakfast, we’d count up how many pennies were in the bowl, and then I’d add a penny to the bowl. On the first day, we counted up ten pennies and added one. On the second day, we counted up eleven pennies and added one. This was neat at first, but by about day eight or nine, it was kind of boring.
Day eleven hit, we counted them up. Twenty pennies. I put two pennies in the bowl. Day twelve through fifteen, again, kind of boring. Two pennies a day. They were paying attention, but it was kind of dull.
Day sixteen, we put in three pennies. Same for days seventeen through nineteen. Day twenty, we put in four pennies. At this point, I suggested that we take out every ten pennies and replace them with dimes, so the bowl then had four dimes and four pennies.
Then things started getting much more interesting. The first day I dropped a dime in the bowl was around day 30. I dropped a quarter in the bowl on day 40 or so because there was now more than $2.50 in there. On the last day, I put almost two bucks in the bowl and then we went out for ice cream and rented a movie at Redbox.
This is such a brilliant demonstration of the power of compound interest. You show them a small amount of money and a simple rule that’s easy to understand – for every ten pennies in the bowl, we add a penny, so it’s 10% interest. Then they can just watch it grow.
Why did he stop at two months, you might be wondering? Well, if he had continued this through the 31 days of May, he would have had $398.13 in the bowl, by my count. That’s a neat trick if you intend to grow from pennies to buying a Playstation 4 or something like that, I suppose, but it’s a little outside the financial realm of many people who might try this.
I’ve decided to borrow this splendid idea for my own kids. It started with a conversation, where I reiterated the example above. “Let’s say we have a bowl with ten pennies in it. Each night, I put a penny in the bowl for each penny already in there. How much money would we have after two months?”
They started tossing up guesses. One dollar! Two dollars! Six dollars? Nope, the answer was just shy of $20.
Then I modified it. “What if we keep going? How much is in there after three months?”
Again, tossing out guesses. Forty dollars! Eighty dollars! One hundred dollars? Nope, just barely shy of $400!
They were stunned. They didn’t believe me. So, right now, there’s a bowl sitting on our kitchen table with a bunch of pennies in it. They’re watching it grow each day and actually debating what will happen next.
I’m also working to relate this to the real world. I mention to them that returns don’t happen quite this fast in the real world, but the principle is still the same.
“Let’s say I have $1,000 in my investment account. Each year, it earns a 10% return. How much money will be in there by the time your kid goes to college?”
First, we start talking about how many years that will be. My oldest son does some math and concludes that he might have a kid in seventeen years and that kid would be eighteen when he/she went to college, so 35 years is the timeline.
Well, in 35 years, that $1,000 would grow to $28,102. At our local state university, $1,000 would only pay for a small part of a year of tuition. $28,000 would pay for about three years. And you don’t have to do anything but just let that money sit.
They got the idea. Time marches on, and if you let your money be carried by time instead of in your pocket, your money grows and grows and grows.
In fact, as we were discussing this topic this very morning, they asked about their own college savings (which are doing really well, mind you) and why we’re not saving for their children’s future already. The more years, the better, right?
The concept is in their head now, and those pennies growing in that bowl are going to reinforce it.
Now, it’s worth noting here that I’m not getting into the nuances of all of this. I’m using very round numbers for interest rates – 10%, basically – and we’re not discussing taxes or anything like that. There’s plenty of time in life for them to learn all of the details.
What matters is that they understand that if they do something smart with their money, it will go to work for them and earn more money, and if they give it time, the money their investment earns will earn even more money and it just snowballs from there. The pennies in the bowl are a great starting point, and having conversations about it helps even more.
The next trick, of course, is connecting it with their behavior. “OK, we’ve figured out that putting a little aside now will pay for your kid’s college or your retirement… how do we come up with that little bit now?” Frugality and a bit of self control are the answers to that question, and it’s something that they seem to fundamentally understand already, but we’ll take it one step at a time and let them marvel at compound interest for a while.
May your parenting experiences click like this one has.