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.
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.
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!
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