I want to teach my 11-year-old about compound interest. Is there an easy way to illustrate it?
Compound interest is when you earn interest on both the money you’ve saved and the interest you earn.
So let’s say you invest $1,000 (your principal) and it earns 5 percent (interest rate or earnings) once a year (the compounding frequency). After the first year, you would have $1,050 – your original principal, plus 5 percent or $50. The second year, you would have $1,102.50. That’s because the next interest payment equals 5 percent of $1,050, or $52.50.
Increasing the compounding frequency or your interest rate, or adding to your principal, can all help your savings grow even faster.
You can teach compounding using your own change jar and there are lots of good resources on the web.
For the low-tech method, dump your change jar out on the floor and tell your children they will invest $1 at 10 percent interest. Then run through a simulation like the one above, calculating the next interest payment on the principal-and-interest total each time.
For a visual illustration, you can download this (PDF) from The FINRA Investor Education Foundation’s SaveAndInvest.org website. It shows what happens when you save $25 every week in an account that pays 5.5 percent and compounding monthly.
You can also watch this by the Financial Literacy Center, a joint center of the RAND Corporation, Dartmouth College and the Wharton School. It’s for a slightly older audience – probably college students – but it illustrates compounding in way that most pre-teens and teens would understand. It uses the rule of 72, which basically says if you divide 72 by your rate of return, you’ll find out how fast your money will double in value. For example, if you had $1,000 that was earning a 6 percent return, it would grow to $2,000 in 12 years (72 divided by 6 equals 12).
For more money activities for your child, visit our Money As You Grow section.