Compound interest for kids: How to explain it to your children

One of the most important early financial topics that everyone should understand is interest. Simply put, interest is the extra money earned on an investment or paid on a loan. While the concept itself is straightforward, understanding how interest works is much less so.

Many parents open compound interest accounts for kids when they're ready to start managing their own money, and it's important to explain how these accounts earn more value when there's more money in them. Here, we'll help you explain the power of compound interest in terms suitable for kids so that they understand the concept of earning interest on both the initial principal and the accumulated interest over time.

Why compound interest matters: A simple explanation for kids

Most checking and savings accounts use compound interest. However, not all banks offer the same rates, and different financial products calculate interest in different ways. Understanding how all of this works helps you (or your kids) better project how much money an account will have after a certain amount of time. It's a major step towards financial responsibility.

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Simple vs. compound interest

As you probably know very well, interest is the extra money earned on an investment or paid on a loan. An interest rate, represented by a percentage, is a portion of the amount you deposited or borrowed, usually added monthly or annually.

Now it starts getting more complicated. Simple interest is calculated with the principal (the amount of money in an account or the remaining amount owed on a loan). Compound interest is calculated with the principal plus already accrued interest. Even for adults, this can be a complicated topic. Nonetheless, it's one of the most important money lessons everyone should learn.

Breaking it down easily

When you're explaining how compound interest works to kids, try to use real numbers. Money can be fun, of course, but kids should also recognize the value of money and the importance of financial responsibility.

To visualize how compound interest works, use basic math and simple numbers. For instance, start with $100.

Imagine you have $100 that earns 5% interest each year. Here's your formula for year one:

(0.05 x 100) + 100 = $105

With compound interest, next year's 5% interest is calculated with $105. So:

(0.05 x 105) + 105 = $110.25

Use words like "reward" when you earn interest or "fee" when you pay it to simplify some of the more complex language. Or work with them on compound words to connect the concept to other areas of their learning.

Compound interest for kids: Practical tips and fun learning games

While it's crucial to impress upon your kids the value of money to encourage future financial literacy and early saving habits, that doesn't mean it can't be fun. Using real-world examples and activities can be a great way to teach lessons about how compound interest works, investing with compound interest, and more. Kids learn better when they're having fun and can relate lessons to their own experiences, so it's up to you to find a way to connect.

Real-world examples

A great way to introduce saving habits to your kids is with a piggy bank and an allowance. Set a regular time when you pay them an allowance for chores and, each week, count the amount of money in their piggy bank. If they've made smart financial decisions and saved the full amount that you paid them last week, reward them with a slightly higher allowance.

For young kids, you can simplify this by paying a dollar each week and adding one quarter as "interest" each week they save all of their money. For older ones, you can introduce a real compounding interest rate and utilize digital tools like Venmo to pay an exact amount. Just make sure to keep the interest rate manageable for your own wallet!

Charts and calculators

Visual and practical learners may benefit from seeing how numbers rise over time based on a compounding interest rate. There are many charts and calculators online that you can use to show kids how interest works. You could even get a kid's investing app to teach them more advanced topics.

Fun activities to help kids grasp compound interest

A classic money management activity is the marshmallow game. In this game, you put a marshmallow in front of a child and tell them that you're going to leave the room for five minutes. If they haven't eaten the marshmallow when you come back, they can have two marshmallows. If they leave two marshmallows for another five minutes, they can have three and a half. (And so on, as long as you want to play.)

This simple game illustrates the concept of compound interest well. The more your child saves now, the more they'll get later.

Making it interactive: Engaging your child's interest

There's an important through-line for each of the previous tips: Make it interactive. Visualize how interest works with real-world examples, show them how numbers change, and use practical activities like the marshmallow game to make learning fun and interactive.

Wrapping up: Empowering kids with the power of compound interest

Compound interest is an important personal finance topic for everyone to understand, whether you're earning two dollars or thousands. It adds up, after all! Explaining compound interest for kids in simple terms is a great early step toward helping them build a habit of saving and ultimately achieve financial independence.

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