How to teach kids about compound interest
Minimum Wage Millionaire
by Sam X Renick
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Whoever came up with the saying "money does not grow on trees" should be fired. I assume they either didn't read or agree with Benjamin Franklin who said "money is of a prolific generating nature."
Wouldn't it be wiser to use the "money and trees" saying to motivate kids and young adults to become disciplined savers and investors?
It's a perfect metaphor to help explain the compounding principle. Just ask kids to picture orchards and orchards filled with trees, filled with fruit, filled with seeds, which all started from one seed.
After all, compound interest is one of the most-compelling and persuasive tools available to encourage short-term sacrifice for long-term gain. Furthermore, disciplined savers and investors are rarely free spenders, thus accomplishing both objectives.
Money's ability to compound is one of its most intriguing and beneficial features. Compounding does not discriminate. Its magical characteristics work for anyone who chooses to employ it, regardless of their ethnic, economic or social background.
The concept is so powerful that Steve Rosen, Kansas City Star Kids and Money columnist, wrote that it's possible over a lifetime to become a millionaire while earning minimum wage. As incredible as that sounds, the math bears it out.
One of my favorite icebreakers to help initiate a conversation regarding this astounding principle is by asking the old question, "would you rather have $10,000 or a penny a day doubled for 30 days?" It turns out that a penny a day doubled for 30 days adds up to more than 10 million dollars! Of course, no investment doubles daily, but it's a fun way to introduce this important concept.
Another great icebreaker is to ask how many times a dollar would have to double in order to reach a million dollars? The answer is 20. You can then add to the fun by asking "how much money a person would have after ten doublings of the dollar?" The answer is $1,024. Half the work amazingly equals less than one tenth of one percent of the benefits. What a huge error it would be to become distracted and disrupt the doublings at this point, say to purchase an Xbox, an iPad or some other "necessary" item.
The largest doubling is the last doubling, which is worth $524,288 and is equal to the sum of the first 19 doublings. However, the twentieth and last doubling isn't possible without the first and smallest doubling, from one to two.
When something compounds, it grows at a much more rapid rate than one expects. Time is a major ingredient in the compound interest formula, so the longer money remains deposited or invested, the greater and more magical the compounding effect. This explains how it's possible to become a millionaire over a lifetime while earning minimum wage. Let me provide you a few examples of this principle in action.
If an 18-year-old saves $100 per month and earns 6% until the age of 65, he or she will have accumulated $313,187, while only investing $56,400. However, if he or she delays the decision until age twenty-five, he or she will accumulate only $199,149, while investing $48,000. The difference is $114,038.
If the saver happens to earn a higher return of 9%, which is possible but requires more risk, than the difference in either deferring or being unaware of the decision is even more consequential at $420,417. The 18-year-old would accumulate $888,549 versus $468,132 for the 25-year-old. The actual dollar difference in what they would have invested would be $8,400. Whether they earned 6% or 9%, earning an additional $114,038 or $420,417 by starting sooner rather than later is a smart way to accumulate money.
Simply stated, compound interest allows the saver to earn interest on interest as opposed to just interest on principal. For example, assume money deposited for one year earns one hundred dollars in interest. During year two, the original money deposited will earn another year's worth of interest or an additional one hundred dollars. However, during year two, the one hundred dollars of interest earned in year one also earns interest, catalyzing the compounding effect.
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Fortunately, you don't necessarily have to be able to explain this principle in order to use it as a motivational tool. All you have to do is expose kids to a compounding chart or calculator. You can find charts in personal finance books and financial calculators online. I suggest the online calculators because you can personalize saving and investment projections, which will add more motivational fuel to the fire. Or you can always ask your local credit union or bank manager for help.
In summary, the sooner one starts, the less it takes to reach one's goals. So, if it is security and riches you want to create, start saving and investing early, not late.
Sam X Renick is the author of two children financial books, has written and produced children's music on the importance of saving money, and is the founder of the It's a Habit! Company, Inc.
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- Consider these 13 things to teach your children to make their financial lives easier.
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