One of the most important money concepts to teach your kids about is Compound Interest.
Albert Einstein is reputed to have said:
“Compound interest is the eighth wonder of the world,”
“He who understands it, earns it.
He who doesn't, pays it.”
Essentially, if you want your kids to grow up to be financially healthy, it’s super important they understand compound interest. You want your kids to be earning it, not paying it!
What is Compound Interest? (Parent version)
Compound interest is the concept of ‘earning interest on interest’.
Let’s imagine you invested £1,000 and get a return of 7% per year.
If at the end of each year you took the £70 you earned (7% x £1,000) and put it under the bed, you’d get £70 richer every year. This is ‘Simple Interest’.
Now, let’s assume that instead you invested the £70 you earned, so you now have £1,070 invested at the end of the first year. You’d earn an extra £74.90 (7% x £1,070) in the second year. You’d earn an extra £80.14 (7% x £1,144.90) in the third year. Each year, the amount you earn increases. That is ‘Compound Interest’ (or ‘Exponential Growth’)
As the chart shows, after 30 years, the £1,000 invested has grown to over £7,500. Over half of this growth has come from compound interest (‘interest on interest’).
Those people who are financially healthy (and wealthy) are the ones who understand compound interest. They save their money, invest their money and wait for it to grow.
The best thing about compound interest is that it grows whilst you are sleeping.
One key element of compound interest is patience. As the chart shows, the ‘interest on interest’ area is really small for the first few years but then explodes in later years. This is why ‘being patient’ is one of the ‘3 Rules of Wealth’.
How to teach kids Compound Interest?
In my opinion, the use of trees is the best way to teach kids the concept of Compound Interest.
Let’s assume you have a tree. Over time the tree produces a seed (interest). If you plant that seed, that seed will grow into a new tree. Now you have two trees. Both those trees produce a seed. You now have 2 more seeds which grow into 2 new trees (4 trees in total). The 4 trees produce 4 seeds and therefore over time become 4 new trees (8 trees in total). Continuing to double the number of trees over time.
So, from a single tree, you can grow a whole forest.
If one tree can grow into a forest over time, imagine how big their forest could be if they planted trees each time they received some money?!
If kids think of money like seeds, then they could grow their own financial forest. Just like growing a tree, it takes time. Therefore, in order to grow their financial forest, they need to be patient.
ACTION: Talk to your kids about growing money using this tree analogy and encourage them to start planting (saving) some of their seeds (money), each time they receive some.
Teaching your kids how compound interest is paid
Remember in the Einstein quote at the start of this blog, it said, “He who understands it, earns it. He who doesn’t, pays it”.
When I told my daughters this quote, my eldest quite rightly asked,
"What do you mean by 'He who doesn't [understand compound interest], pays it'?"
I explained that in a lot of cases, those that don’t understand compound interest might borrow money from the bank (i.e. go into debt). Those that borrow money from the bank have to pay interest on the money they have borrowed. The bank then gives some of the interest paid from the borrowers to those that have saved money with the bank. So, the borrowers are 'paying it' and the savers are 'earning it'.
Also, someone who doesn’t know about the magic of compound interest is likely to spend all their money. The money they spend goes to different companies. Those companies get richer. The people who own those companies (the investors) are also getting richer.
This means those that have invested their money, i.e. those that understand compound interest, are getting wealthier from those who spend all their money, i.e. those that don’t fully appreciate the power of compound interest.
For my kids, I bring this to life when we go to the shopping mall. We can look around and see all the people spending their money and know that, in most cases, some of that money is coming to us (as we invest in a fund which means we own a small bit of thousands of companies). Even when we spend (which we like to do), some of that money will go to companies and come back to us.
Helping your kids to ‘earn it’
One of the best things you can do to help your kids benefit from compound interest is to make sure they have some money saved in either a savings account or, better still, an investment account.
Setting up an investment account:
For those of you who are interested in opening an investment account, here’s a quick guide:
Open a junior investment account (Vanguard, Fidelity, Hargreaves Lansdown etc)
Invest in a high quality global equity* fund with low fees (less than 0.3% per year)
Make sure it’s an ‘accumulation (acc) fund’ so that it reinvests your dividends (earnings) automatically
Moving forward, contribute some money to that account every month (automate it)
* ‘Equity’ is the jargon term for stocks and shares
For more information on investing then please see our 3 step guide to opening an investment account. Also, don’t forget to teach your kids all about the stock market by reading this blog. Please speak to a financial advisor if you need help selecting a specific investment fund for your kids.
Don’t delay, the younger your kids start saving and investing, the sooner compound interest can start to work its magic.
Summary: Teaching kids about Compound Interest
In order for your kids to grow up financially healthy, make sure you teach them about compound interest. Use the tree analogy to help them visualise it.
Once you have taught them, then help them start earning by setting up a savings account or an investment account. Whilst their money might not grow very fast at the start, by the time they are adults they will be benefiting from all those years of compounding.
In one of my most popular blogs, Rich Kids vs Wealthy Kids, a key point was that wealthy kids understand compound interest, rich kids don’t.
Thanks for reading!
Will
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