Using Compounding Interest to Generate "Money Interest" Among Children

Using Compounding Interest to Generate "Money Interest" Among Children

April 03, 2023

You may not be aware of this, but April is National Financial Capability Month, an initiative designed to provide resources to encourage Americans of all ages to increase their knowledge of personal finances and investing.

While I would argue that increasing financial literacy is something we should be doing all year long, I might suggest that parents and grandparents use this month to empower their children and grandchildren with the knowledge they need to become smarter about money.

Creating a budget to track spending. Helping them open their first savings account. Learning how stocks, bonds, mutual funds and ETFs work. There are countless ways you can help kids learn more about saving, spending, investing and donating their money.  

However, a risk of discussing some of these more esoteric topics with younger children is that their eyes may glaze over.

That’s why a good way to ease them into the subject is to gear it toward addressing that universal question, “What’s in it for me?”

First, ask them if they want to have a lot more money than they've saved in their piggy bank.

If any of them say “No,” they’re probably trying to pull a fast one over on you. You’ll find out how they really feel if you suspend their allowance or they find nothing under their pillow from the Tooth Fairy.

For those who say “Yes,” start by showing the power of compounding.

An article from last year explored compounding within the context of motivating teenagers to start saving for retirement as early as possible.  

But for younger children, you might want to simplify this discussion by illustrating how a little money put away today could grow a long way later on.

Show and tell

My favorite tool for this purpose is the Compound Interest Calculator at Investor.gov. It’s very simple. Just put in an initial amount to invest, an annual interest rate, and how many years you want to keep it there.

You’ll see the result as well as a chart illustrating how compounding could theoretically increase the amount over time.

Your children and grandchildren (and maybe you, too) will be surprised at how large even a small initial investment could grow.

Here’s an example. Let’s say you made a one-time contribution of $100 into an investment account for a child who is 10 years old. If you never added another dollar, and the account grew at an 8% interest rate, compounded quarterly, it would be worth $11,588 (in today’s dollars) when they were 70 years old.*

To illustrate this point, you could show them a chart like the one generated by the Investor.gov calculator.



The lesson here is that the key to building long-term wealth is time. The earlier they start saving, the more time they’ll have to take advantage of compounding.

Show the exponential impact of regular contributions

Hopefully, if their eyes light up at this example, you can move on to show the even more impressive benefits of making regular contributions to an investment account throughout their life.

Using the same assumptions as the first example, add an additional monthly contribution of just $10 per month on top of the initial $100 investment.

At that same hypothetical 8% interest rate, their savings would have ballooned to $183,922 (again, in today’s dollars) at age 70.*



Inject some variability into the mix

If you wanted to take this a step further and show them how variations in returns over this period might result in either higher or lower results, enter a numerical value in the “interest rate variance range” field.

For example, using the same assumptions in the second scenario, if you entered “2” in this field, the chart would add the results of 6% and 10% compounding returns to the original 8% example.*



Hopefully, seeing these examples will motivate the kids to start saving for specific goals, such as college.

If they’re under age 13, you could set up a plan for them to put aside some of their allowance, birthday and holiday gifts, and money earned doing chores into a savings account. Then sit by their side as they transfer some of that money into their 529 College Savings Plan account.

If they’re teenagers and earning money from a part-time job, you can help them jump-start their retirement savings plan by establishing a Minor Roth IRA that they can fund with contributions from their bank account. You could incentivize their saving by matching their contributions with your own money, up to the total amount they earn in a year or $6,500, whichever is less.

Under your careful supervision, your teen could use this IRA to learn more about investing and gain first-hand knowledge of the potential benefits and consequences of their investment decisions.    

More financial literacy resources

If seeing the benefits of compounding motivates your children and grandchildren to become smarter about money, consider expanding the discussion to encompass other personal finance topics. For tips and tools to aid in this effort, I invite you to listen to my colleague Joelle Spear’s Plan for Life with Canby Financial podcast, Helping Your Kids Become Smarter About Money, available in the podcast area of our web site.

You may also want to speak to a financial advisor for additional ideas that can help everyone in your family increase their financial literary all year round.

 

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This article was authored by David Jaeger and Jeffrey Briskin. David is a financial advisor at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or djaeger@canbyfinancial.com  Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.


 *The hypothetical examples used in this article are for illustrative purposes only. No specific investments were used in these examples. Actual results will vary. Past performance does not guarantee future results.

©2023 Canby Financial Advisors.