how does compound interest work? | how to explain compound interest to your kids
How does compound interest work and how do you explain compound interest to your kids? Many parents have worked hard to learn about how to manage their own money, and how to start investing for their future, so naturally they want to equip their kids with the same information! Starting with a basic understanding of compound interest is a great place to start. But sometimes the concept even confuses us, right? Here are some simple ways to teach your kids about what compounding interest is and how they can earn it through investing as they get older. Also have a listen to the episode below from my millennial investor, where Nick explains how you can make your kid a millionaire:
What is compound interest?
Compound interest is a powerful way to maximise investing for the long term. It’s why so many people invest, and why so many parents want to teach their kids to invest! Essentially, compound interest refers to the idea that when you invest money, it can grow not only from the original amount you invested but also from the interest earned over time. As time goes on, the interest you earn is added to your initial investment, creating a snowball effect. It compounds over and over. This means that not only does your money grow, but the growth itself also earns more growth. By understanding this concept, children can grasp the idea that starting early and consistently saving and investing money can lead to significant wealth accumulation in the future.
How do you explain this concept to your kids?
To teach your kids about compound interest you need to get some activities going! Sitting down and talking about compound interest might be enough for your kids depending on their age and learning styles, but don’t be afraid to get up and be active so they can learn in a really hands-on way if that’s what will work for them.
Activity 1 – the yummy treat game (younger/beginner)
Many of us have heard about the marshmallow experiment which was run as a study in the 1960s by Stanford University psychologist, Walter Mischel, observing how preschoolers understood the idea of delayed gratification. They gave each child one marshmallow and told them that if they could hold onto that marshmallow until a researcher returned to the room that they would be given another marshmallow, and on and on it would go. Of course there would be kids who ate their marshmallow straight away (yum right) and would have to start the cycle afresh. But there were kids who realised the benefit of holding onto that initial marshmallow until the researcher returned to the room, as they realised that another marshmallow would be coming their way if they could sit tight. This is a delicious activity that could be used to teach the idea of investing! Exchange the marshmallow for whatever sweet treat your kids love (or healthy treat if you’re trying to cut back on sugar lol). You could also then advance this concept with some fake (or real) coins – giving your kids one coin a day and highlighting that if they can hold onto that coin day after day, that there’ll be another coin added to their collection every day. Write down each day how much is in their collection and show them how it’s growing thanks to keeping it invested.
Activity 2 – the investing piggy bank/jar (intermediate)
Money lessons can be tricky with the online nature of banking so a great way to teach can be to use physical money before showing them money management and investing online (might need to hit up the ATM for this!). We can apply the marshmallow experiment concept to this physical example – start by giving your kids a piggy bank or jar that you can place on a shelf at home. Whether they have an allowance or earn money doing chores for you or your neighbours and friends, encourage them to add their income to the jar or piggy bank (you might also encourage them to set aside an amount to save, spend and give, but for simplicity’s sake focus on one concept at a time). For each day they ‘invest’ money into this ‘investment piggy bank / jar’ add some interest by dropping in some extra coins. Write down on a piece of paper what the balance is everyday and show them how compounding interest is helping it grow faster and faster each day.
Activity 3 – the at-home investing game (more advanced)
You may have heard about paper trading before, which is essentially simulated investing with fake money. Investor nerds and enthusiasts love to do it to test their investing skills and theories, often in competition against others. You can downscale this idea and get the whole family involved!
Explain that you’re going to be playing a game where they’ll have some money to invest into businesses they like in your fake ‘city’ or ‘town’.
Grab some cardboard and create some fake companies that operate in your ‘city’ or ‘town’. Pick a few different types of businesses that your kids understand and put them on display on the wall. Each day allocate a share price to each business so you can calculate how their investments are growing.
Give them each some cash and encourage them to ‘invest’ this money into whichever businesses they want! Track how their initial investment grows and demonstrate how reinvesting their money each day brought about better results.
As with all teaching it’s best to start simple and build from there. As you’d know yourself from your own investing, you don’t learn everything about investing overnight. Pace yourself as you show your kids how compounding interest works. Aim to teach them slowly over time and check in with them to see if it’s making sense. Adjust these activities according to what you know will work with your kids! Kids all have different learning styles so adjust as you need.
Power to all the parents out there!
Where to now?
Subscribe to my millennial money and my millennial investor to learn more about managing money and investing!
Here’s what Bluey is teaching your kids about money and careers
Read more about basic investing concepts
