How to Teach Compounding Interest to Kids

Compounding interest is one of those mathematical mysteries that we tend to take for granted. We all hope through diligent savings over the course of many years, compounding interest will continue to do its thing behind the scenes, doubling, tripling and sometimes even quadrupling our money over an investing lifetime.

Most adults do not fully appreciate its power and chose to ignore the benefits of making compounding interest an ally at an early age. If grown adults do not fully understand the inner-workings of compound interest, imagine trying to explain it to your kids.

In my own words

I’ve tried to explain compound interest to my daughter, who is eight years-old. She nods in agreement with everything I say, and when I’m finished she summarizes back to me, “So, you are saying if I put $100 in the bank then when I turn sixteen the bank will give me $200?” That’s a pretty aggressive return, but she has already grasped more of the concept than I understood at her age (and older). She is kind of like her dad, she understands these concepts, but they are not really solidified for her until she sees them in action.

Compounding Pennies

I gave my daughter a Ziploc bag with a handful of pennies and told her over the course of a week I wanted her to give me a penny a day. For the next seven days I would be her personal banker. I would deposit the penny in “The Bank of Dad” and compound interest would begin to accrue the day she deposited the penny. At the end of the week we would check her balance at the “ATM” (Automated Tell-me-how-much-money-my-dad-has-for-me Machine). Fortunately, she is already checked out on how to use this kind of ATM.

Each day my daughter handed over one penny at the breakfast table and I deposited it in her bank - which is really just an old plastic film container with a lid. I gave her a “receipt” for her deposit and explain that she needs to keep up with the receipts to see how much money she has added to her account. In an effort to make this a little more realistic, I deposited a penny from my own piggy bank every other day to give her an additional four pennies at the end of the week. I could have just matched her penny for penny, but I didn’t want to set the unreal expectation that it is easy to double your money in a short time.

Balance Inquiry

On Sunday evening we gathered receipts and confirmed she had deposited seven pennies in “The Bank of Dad.” I asked her how much money that represented, and she correctly told me, “Seven cents.” Using that ATM she is so familiar with, she performed a balance inquiry. I opened the old film container and counted out its contents – all eleven pennies. “Hey, there are four extra pennies in there!

Yes! She got it! I explained that her original seven pennies had grown to eleven pennies because every couple days the bank paid her a penny for letting them use her money – that’s interest. I gave her back all the pennies and told her to put them in her savings envelope. She paused and asked, “Dad, what would happen if you deposited like a hundred million pennies in the bank?” Well sweetheart, you would have a lot more money than The Bank of Dad does!

Consider one of the best online banks to park your kid’s savings.

Comments

  1. So perfect! This made me smile this morning! I remember being young and my dad sitting my brother and I down at the kitchen table (that is now my kitchen table) and getting out yellow lined paper and how compound interest works. He’d write out example of Smarty and Dufus. Smarty makes $50K/year and invests $10K per year for 30 years and Dufus makes $50K/year and doesn’t “get it” until he’s much older and therefore spends 20 years getting behind so then he has to save that much more once he’s older (and maybe hopefully making enough more money to make up for it) to get to where Smarty is.

    It still makes me laugh that my dad was teaching us stuff like that when we weren’t even 10 years old. Your way is so much cuter than charts and graphs and lectures :)

  2. Thanks, FrugalDad!

    Wish my parents had taken the time to devise a teaching moment like this for me when I was young! Actually, they probably weren’t aware of compounding interest themselves. . . . so maybe it’s not too late for me to teach it to them!

  3. Awwwww, that WAS a nice story to read this morning!!! You two are so cute. and what an awesome way to explain things. When you can touch and feel how things work (literally), it sinks in a lot more for some. some = myself included, i’m totally visual and hands on.

    Thanks for sharing!

  4. You should have added another element of reality to this though too.

    You should have charged her 4 pennies ATM fee to get HER money back. Then charged her 8 pennies in monthly service charges. Uh-oh you don’t have enough pennies? I guess then daddy needs to charge you another 4 cents in overdraft fees and 1 cent interest in on the overdrafted amount.

    But really, great way to show kids about interest!

    I set up bank accounts for my daughters and my 8 year old just made her first stock purchase (with a little help of course). Kids can get it, we just need to give them some help!

    http://thefrugalcanuck.blogspot.com

  5. This is a great post. I linked to it on my blog, and I’m adding frugal dad to my blogroll. I’m enjoying reading some of your earlier posts as well. Keep up the great work.
    Please check out my blog when you have a few minutes. I’d appreciate any input!

  6. Great post! Perfect. I like the comments from the frugal canuck, too!

    Consider submitting this post to my Kids and Money blog carnival — it’s absolutely perfect. Thanks!

  7. According to my calculations, 4¢ interest on a 7¢ balance, represents a WPR (Weekly Percentage Rate) of 57%. That means that compounded weekly, for the course of one year, the original 7¢ balance would grow to $1,076,167,730.38, that’s right, more than a BILLION dollars.

    Now THAT may get her attention even more. But, The Bank of Dad might need to get FDIC bailout first. :-)

    Then there is always the old adage, “What would you rather have for allowance – one penny, doubled every day, or $20/week?”. Of course, taking the pennies ends up earning roughly $42,949,672.95 in a month while opting for the Andrew Jacksons earns a measly $80.00.

  8. you know, i tried to explain the wonders of compound interest to my niece. she didn’t seem too impressed. she seemed more interested in when she was going to get her first credit card! haha…i guess i still have some work to do :D

  9. With a kid on the way (read about it at my blog) I can’t wait to be able to teach my kid the wonders of money. This is a great story and one I hope to be able to use with my children in the future.

  10. Great to see the math on that, Frugal Bachelor. I wouldn’t mind having such a dad…but you’re right about the bailout. :)

    That’s a wonderful lesson, Jason. :)

  11. This is a really cool way to teach your child a concept that even some adults don’t understand…that is, until they get in trouble when the bank uses these very same principles AGAINST them in the form of a credit card or loan.

    I have saved this to my links for homeschooling. Thanks a lot for the info!

  12. What a great simple way to explain compounding. Not sure how I tried to explain it to my daughter but she knows she doesn’t want to take money out of her account! We set up an ING sub-account in her name and I explained that the money earns money and that money earns money and so on. She asks all the time what she has in there and she’s always happy to hear that it went up a few cents.

    I might have to try your technique and see how much my daughter actually got of my teaching!

  13. Thanks for the the post. My first son is now 2 and half and we have been really thinking about how to be intentional about teaching him about money. This was a great little exercise.

    Did she want to do it again the next week or when she wanted something?

  14. man, this is the first I’ve heard about compound interest! sheesh! yes your daughter is lucky! =) I wonder how much interest my bank pays… I think it’s about time I leave something in there! thanks!

  15. What an interesting way to explain this to a young child! It’s simple, but it gets the point across.

    I too, also found that this is a concept many adults are unfamiliar with, and certainly most younger people (teens, college students, etc..). This is a HUGE problem, because, as you say, starting young is very importnat when it comes to compound interest.

    For those who would like to know more about compound interest, including how it works, and why time frame matters, please check out the article I wrote:
    http://www.btgnow.net/2008/08/compound-interest-is-free-money-part-1-simple-vs-compound-interest/

    Great post, I’ll remember this trick if I ever have to teach kids!

  16. Another great tool for teaching children about managing money and the value of being debt free is Cashflow for kids the game by the guy who did the series “Rich Dad Poor Dad.” It’s been really great with my children.

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