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?

‘Compound interest’ simply means earning interest on your savings, and also, eventually, on the interest that those savings earn.

The earlier your child begins to save, the more compound interest they'll earn. An adult example would be, say, $1,000 to save. Investing that $1,000 at an interest rate of 4% p.a. means that at the end of year one, you would have $1,040. During year two, you would be earning interest on a balance of $1,040 – or in other words, earning interest on both your initial savings plus the interest that those savings have 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.

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Things you should know

This article is intended to provide general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this, consider the appropriateness to your circumstances.