When trying to teach kids about the value of compound interest – or the time value of money– one possible place to start is with a small number of marshmallows.
The 'marshmallow test'
In the late 1960s, Stanford University psychologist, Walter Mischel ran a series of delayed gratification tests on a total of 653 three to five year-olds. One well-known example was the marshmallow test, whereby each preschool child was left alone in a room with one marshmallow and a promise that if they could refrain from eating the sweet until the researcher returned, they would receive another one. The focus of the test was on the ability of the children to exercise restraint, but it could also work as a good lesson in how compound interest works.
What is compound interest?
Put simply, compound interest is when you earn interest on both the money you've saved and the interest you’ve already earned.
Kids can earn compound interest by simply keeping their initial deposit and any interest earned on it in their savings account.
The earlier your child begins to save, the more compound interest they'll earn. So, for example, if they deposit $100 into a savings account which pays interest annually at a rate of4% p.a., at the end of year 1, they’ll have $104. During year 2, they’ll earn interest on a balance of $104 – which means they’ll be earning interest on both their initial deposit plus the interest the deposit has already earned.
Teaching kids about interest
The example above might be beyond young kids, but there are plenty of fun compound interest lessons you might try with them. An easy step-by-step example is:
- Give your child a small sweet (or marshmallow). Ask them how long they think they could save it for, before eating it. Offer to give them an additional sweet for each day that they can keep their sweets uneaten. This helps children understand the concept of reward for saving.
- Then perhaps expand the lesson with coins. Give an initial small amount of money to your child (perhaps 50 cents) and offer to add to the amount each day for as many days as your child can continue to save. Gradually increase the daily amount that you provide (for example, 10 cents, then 15, then 20) to mimic compound earnings.
- Explain that money in the bank earns interest. Once your child has practiced 'saving' their sweets and has grasped the concept of earning more by saving more, you can explain that money invested in a savings account works in a similar way– that the earlier they save, the more compound interest they can earn.
FAQs
Explain that interest is money a bank pays you for keeping savings there. The bank sets interest rates—what it pays per dollar saved. Higher rates mean bigger payments.
How to explain simple interest to a child? ›
When the fee charged for borrowing money is a fixed yearly percentage of the amount borrowed, it is called simple interest. The amount borrowed is called the principal, or the present value of the transaction. The amount owed at the end of the lending period is known as the future value of the principal.
What is interest in simple words? ›
Interest is the price you pay to borrow money or the return earned on an investment. For borrowers, interest is most often reflected as an annual percentage of the amount of a loan. This percentage is known as the interest rate on the loan.
What is interest in children? ›
personal interests – these are a child's favourite things, such as cars, water play, or music. situational interests – these interests emerge when something about an activity, material, or person attracts a child's attention or invites him to become involved.
How can I explain interest? ›
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct from a fee which the borrower may pay to the lender or some third party.
What is interest explained to kids? ›
Explain that interest is money a bank pays you for keeping savings there. The bank sets interest rates—what it pays per dollar saved. Higher rates mean bigger payments.
What is interest for dummies? ›
Before we dive into the nitty-gritty details, let's start with the basics. Interest rates, simply put, are the cost of borrowing money or the return on invested capital. They represent the percentage that is added to the principal amount over a specified period.
How do you explain simple interest? ›
Simple interest is the interest charge on borrowing that's calculated using an original principal amount only and an interest rate that never changes. It does not involve compounding, where borrowers end up paying interest on principal and interest that grows over multiple payment periods.
What best describes interest? ›
Interest is the monetary charge for borrowing money—generally expressed as a percentage, such as an annual percentage rate (APR). Interest may be earned by lenders for the use of their funds or paid by borrowers for the use of those funds.
What best defines interest? ›
Interest is the amount you pay to borrow or the amount you earn on your savings. High rates are great for savers, but not so good for borrowers.
: a feeling that accompanies or causes special attention to something or someone : concern. b. : something or someone that arouses such attention. c. : a quality in a thing or person arousing interest.
What is simple interest easily explained? ›
Simple interest is a method to calculate the amount of interest charged on a sum at a given rate and for a given period of time. In simple interest, the principal amount is always the same, unlike compound interest where we add the interest to the principal to find the principal for the new principal for the next year.
What is simple interest in layman's terms? ›
Simple interest is an interest charge that borrowers pay lenders for a loan. It is calculated using the principal only and does not include compounding interest.
What is simple interest for beginners? ›
Simple interest is calculated by finding a percentage of the principal (original) amount and multiplying by the time period of the investment. The final value of the investment can then be found by adding the simple interest to the principal amount.
