Interest can be a tricky concept for kids to understand because this one thing can both add to our wealth and cost us a lot of money. It is helpful to explain right off the bat that interest can be earned (i.e., we make the money) and interest can be paid (i.e., we owe the money). Since kids cannot get mortgages, car loans and credit cards, most will avoid paying interest (unless you charge for loans). But tweens are old enough to see how paying interest affects you: show them your credit card bill and point out the section that states how long it will take you to pay off your balance if you make only the minimum balance, and pay special attention to the amount of interest you will have to pay.
Explain that people earn interest when they loan money to the bank. If you have a savings account, for example, the bank pays you a small amount of money as a "thank you" for depositing the money with them. The bank, incidentally, uses your money - that’s why it pays the interest. Remind kids, however, that their money is safe and can always be withdrawn at any time - even if their particular coins and dollar bills have been used by someone else.
While interest alone may not amount to much, it is the power of compounding that can help build wealth over time. Compounding is when you earn interest on interest, and it allows your money to grow over time. To illustrate the power of compounding, ask your child, "Would you rather have one million dollars, or start with one penny and double your savings each day for four weeks?" Because a million dollars is a lot, and pennies are not, most kids will confidently choose the million dollars. Now show them this chart:
As you can see in the chart, at the end of the first week they would have only 64 cents. At the end of week two, they would have $81.92. At this point, it doesn’t look at all like they will be able to do better than a million dollars. But by the end of week three, the balance is up to more than $10,000, and by the end of the four-week period, they would have been a millionaire!
Is this realistic? Not at all, since during the last week we would have to come up with hundreds of thousands of dollars each day to meet our daily doubling goal. But this does serve as an example of what can happen when you give your money the biggest advantage you can: time. The magic of compounding allows you to generate wealth over time, and requires only two things: the reinvestment of earnings, and time.
Here is a more realistic example to help explain compounding and the importance of time. Assume you put $1,000 in the bank today and it will stay there until you turn 50 years old. The following chart shows how various interest rates would add up over time depending on how young you were when you started:
As we can see, the sooner you start and the better the interest rate, the more your money would grow by age 50. You can use online calculators (search for "compounding calculators") to plug in different figures including the initial balance, years to grow, monthly contribution and interest rate. It is fun to play around with different numbers, but make sure your child understands that interest rates are generally low; today, for example, interest rates for standard savings account tend to be around 1%. You can search online for the most competitive interest rates, or talk with an associate at your local bank to find out rates for kids’ savings accounts and other products.
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