As a parent to be, I can’t help but think about all of the things that I want to teach my kids that they don’t learn in school. Education regarding business and finances top that list. Below is my plan for teaching my kids about interest. If you have kids, and especially if you have done something similar, please comment on how it has worked for you and include any suggestions that you might have! For convenience sake, I will describe what we will do as a kind of tutorial, in case you wanted to give it a try. This also makes it easier to describe the process.
When you start providing the child with an allowance, encourage them to put some money into the “bank.” Whether a bank is actually used or not is immaterial — the bank could be a coffee can. The important thing is that interest is paid to encourage saving.
To start, pay an excessive interest rate. For example, if the child gets $4 a month, and saves $1, you could pay $.25 per month per dollar saved. It is important to keep the principle (the money saved) separate from the interest (the extra that you pay the child for saving), because you are only going to pay ‘simple interest.’ This means that after 4 months, when the child has an extra dollar in interest, you are not going to pay an additional $.25. When you determine how much interest to pay, make sure that you can afford it. Using our example, if the child saved $1/month and did not take any money out, in month 12, you would have to pay $3 in interest, just for that month! The lower the allowance for the child, the higher the interest rate I would pay as an incitement for the child.
As the child ages, they may ask why they are not receiving interest on the interest they have been paid. Smart kid — this is what is known as compound interest. If they don’t ask, you should introduce the idea to them. At this point, you will want to reduce the interest rate that you are paying. Why you ask?
The rule of 72 is a rule of thumb used to determine how long it will take an investment to double in value. You take 72 and divide it by the interest rate to determine how long it will take the investment to double in value. At 10% interest per year, it will take an investment 7.2 years to double in value. At 10% per month, it will take 7.2 months to double in value. In our example, we are paying 25% per month. 72/25=2.88, so if the child put $1 into the ‘bank’ and nothing else, it would be worth approximately $2 in month 3, $4 in month 6, $8 in month 9 and $16 in month 12. In other words, in addition to the allowance you pay the child, you also pay an additional $15 of interest on that first dollar alone. Needless to say, this is unsustainable.
If you pay 5% per month (this is still a whopping 60%/yr), at the end of 2 years, you will be paying about $2.33 per month of interest. The child will have saved $24, but their balance will be almost $47. This is probably sustainable for most people for a few years. Obviously, you will need to show the child that this lower interest rate is actually better for them due to compounding. It would be helpful to sit down with the child each month and compare: the amount of principle, the amount of interest, how much they would have had with simple interest, and the amount that they have with compound interest. Keep a ledger to compare the amounts so that the child can get used to calculating interest using each method and comparing the amounts earned using each method.