Compound interest is a difficult concept for even the most financially savvy adults to fully grasp -- the idea of our money earning interest, the interest building interest, and so on, is hard to compute.
Now think how challenging it can be to explain compound interest to a child who’s just learning the basics of saving money and financial responsibility.
If this puts you in a parental quandary, don’t worry: It doesn’t need to be as complicated as explaining the theory of relativity. It’s basically all about how time affects money’s value.
Try some of these simple, basic ways to teach your kids about compound interest.
“Interest” tends to be a word we take for granted, since we usually haven’t had to explain it to anyone.
Keep it simple, especially if your kids are younger: Interest is what a bank pays you to keep your money there. The longer the money stays in the bank, the more money you earn.
Get them thinking about it. For example, ask them if they’d like to have $10,000 right now, or a penny.
Naturally, most kids will choose the larger amount.
Then elaborate on your question, and don’t be afraid to exaggerate to illustrate how interest works. Tell them the penny will double its value every day they leave it in the bank. Do they still want the $10,000, or will they now choose the penny?
At that unbelievable rate, after 30 days, they’d have more than $5.3 million. By day 31, they’d have $10 million! This growth isn’t at all likely, but it helps make the point.
Of course, you’ll also want to talk about the other aspect of interest: paying it.
When bills aren’t paid on time, interest continues to add up -- only instead of earning more money, they’ll owe more. This explanation is especially important as kids get older and approach the age they might get their first credit card.
Even young children can learn about accruing interest the next time you lend them a few dollars. Explain how when you borrow money, it accumulates interest while you pay it back.
Tell them you’ll lend them the $5 they need, but they’ll actually owe you $5.25 for the privilege of borrowing the money -- and if they take too long to pay it back, their debt will keep growing.
Once you’ve explained a bit about what interest is, try these steps to illustrate what you mean:
Before trying out coins and currency with smaller children, show the value of saving versus spending with the classic marshmallow test.
Give your child one marshmallow (or a favorite candy) 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 three the next day.
This can be a good, tangible lesson about how delaying gratification can increase something’s value, according to Kasasa.
Give your child a piggy bank or plastic jar, suggests Jason, the blogger behind The Frugal Dad and father of an 8-year-old daughter. Offer them a bag of pennies and tell them to deposit one cent a day into the “Bank of Mom or Dad.”
Every other day, as they continue to make deposits, put another penny in your child’s bank as “interest.”
While you could match them penny for penny, as Jason explains, “I didn’t want to set the unreal expectation that it is easy to double your money in a short time.”
Later, you can start adding cash and other bills into the mix to add variety and teach them money is made up of all sorts of coins and paper bills.
This bank is like an ATM: Kids can take their money out anytime, but there won’t be any left to collect interest. This gives them the incentive to watch their money grow and teaches them about choices.
Like any lesson, it’ll sink in better when it’s fun.
Try the checkerboard method. Start with a large bag of coins. On Day 1, have your child place one penny in the left bottom square of the board.
Each day, they collect double interest from the banker (that’s you) and put those coins on the next square. On Day 2, they’ll have two pennies, Day 3 they’ll have four pennies, Day 4 they’ll have eight pennies, and so on.
Once they’ve collected enough interest and stacked the pennies until they fall, they’ve reached their savings goal.
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%.
To help kids track their progress toward a savings goal and account for compound interest, keep things visual. Try drawing up a savings goal chart and putting it on the wall.
At the end of each week (and especially at the end of each month), mark their progress. Write down how much they have in their savings, along with how much interest they’ve earned.
Part of the agreement might be they’ll withdraw some of their interest-bearing savings to pay for it -- a good springboard for a discussion on budgeting.
While offering 40% or 50% interest is helpful for the sake of demonstrating the effects of compound interest, explain to your kids the interest rate from a real bank won’t be that high.
In time, you can guide them along the way when it comes to all things interest-related, like eventually getting a credit card, taking out their first car loan or student loans or securing a mortgage.
Your Turn: Have you taught your kids about compound interest? What strategies or games did you use to illustrate the concept and help them understand its power?
Paul Sisolak (@PaulSisolak) is a freelance writer who writes about all things personal finance. He’s been featured in U.S. News & World Report, The Huffington Post and Business Insider, among others.