Compound interest is a term that is regularly used in the world of finance. Despite its complicated name, it's a simple concept that is relevant to savings and debts. If you explain it in the right way, your kids can get to grips with what it is and how it helps your money to grow. Here's what you need to know.
What is compound interest?
Compound interest, also known as compounding, is when you earn interest (money) on both the money you save and the interest you earn on that saving. So every year when you earn interest, you also earn interest on the interest itself.
The rate at which compound interest grows also depends on the frequency of your interest payments. If the interest period is quarterly or monthly, rather than annually then the total amount of interest paid across the year will be higher. This is because interest, being paid on interest, accumulates in these smaller periods.
How does compound interest work (with examples)?
The best way to understand how compound interest works is by taking a sum of money, such as $1000 with an annual interest rate of 10%
- By the end of the year, you will have earnt $100 in interest, making your total $1100.
- The following year you would earn $110 in interest (10% of the original capital and 10% of the year one interest).
- The year after you would earn $121 in interest (10% of the original amount of $1000 and 10% of year two interest), and so on.
What is the compound interest formula?
The formula for calculating compound interest is:
P = C (1 + r/n)nt
- 'C' is the deposit
- 'r' is the interest rate
- 'n' is when the interest is paid
- 't' is the length of the investment
- 'P' is the final value
The best way to understand this is to imagine you put $100 into a savings account with a 5% interest rate. Five percent of $100 is $5 so after a year your money will have grown to $105. The next year, you’d earn 5% on the new amount of $105, so instead of $5 interest you’d earn $5.25 and this continues to grow with every year of your investment.
What are the pros of compound interest?
The biggest pro to compound interest is your money grows faster. It means more money than an account with a simple interest rate because you earn money on the money you invest and the interest.
What are the cons of compound interest?
The cons of compounding are it only works over a long period. This is not for short-term goals or if you want to keep withdrawing money from your investment.
It's also worth knowing compound interest also works on debt, making debts spiral out of control. This occurs when compound interest gets added to the amount borrowed, and then the interest rate also applies to the new (larger) principal sum.
It's interest on interest, which increases how much you owe.
How can you best take advantage of compound interest?
To take advantage of compound interest, it's crucial to start early and be consistent with your savings. One way to motivate yourself to keep going is to use a compound interest calculator to see how you can increase your initial amount.
For instance, if you invest an initial lump sum of $500 and add $600 every year ($50 a month) for ten years, at the end of this period, compound interest would leave you with $8,481.19 compared with $6500 without interest.
What is the difference between simple interest and compounding interest?
Simple interest is based on the amount of your deposit. Compound interest is based on the amount you deposit and the interest that accumulates in every period (monthly, quarterly, annually).
Why you need talk about interest to your kids
Conversations about savings, interest, compound interest, and investments are a vital part of financial education. Showing your kids how to save, invest money, and grow their money is key to helping them remain financially stable for life.
What's a simple way to explain compound interest to kids and teens?
The best way to explain more in-depth financial terms to kids is to make it age-appropriate and start with the basics. Bear in mind that these are challenging topics to understand so it’s better to repeat your message a number of times with activities that help drive the message home.
Start by explaining that when we put our money into a savings account the bank can use the money to make even more money. For this, they pay us back and this is called ‘interest’.
Interest is a small percentage of the amount of money we have in the account.
Compound interest is a faster way to grow money without having to do anything! This is because the bank will pay interest on both the money you add to your account and any interest you earn from the bank. So it’s interest paid on your interest.
Money Missions on the GoHenry app has fun videos and quizzes, designed to build crucial money skills from an early age. It’s perfect for age-appropriate resources around savings, interest, and compound interest.
Different activities will also help teach kids about compound interest.
- With younger children, give your child a small piece of candy. Then, offer to give them an extra piece of candy if they keep their piece of candy uneaten by the end of the day. Then, tell them if by the next day they manage to keep both pieces uneaten, you will double the candy they get, so two become four, and four become eight. See how long you can keep them going. This teaches children the concept of earning a reward (interest) for saving and delaying gratification (a key component of saving).
- You can use a similar technique with teens and their allowance. Challenge them to save 50% allowance every week for a month and say if they manage this you will reward them with interest that matches their weekly savings.
So if they get $5 a week, and save $2.50 every week for four weeks they will have a total of $10 by month's end. This will earn them a reward/interest of $2.50 every month.
Another game can be done with the compound interest calculator. Open it up and get your child to enter in different imaginary amounts, with different interest rates, to see how fast their money will grow. They’ll be surprised by the outcome.
Start great financial habits with GoHenry
Our in-app Money Missions can help your kids learn about savings, interest, and compound interest. Money Missions are fun bite-sized lessons for every age, with the lessons tailored to your kid's age and understanding. They can also learn about borrowing and investing, ready for when they are an adult.
