How to explain interest and the time value of money to kids
Helping kids to understand the benefit of saving early can reap big rewards.
When trying to teach our young children about the value of compound interest – or the time value of money - one possible place to start is with a small number of marshmallows. Truly.
In the late 1960’s 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.
‘Compound interest’ simply means earning interest on your savings and also, eventually, on the interest that those savings earn. The earlier you begin to save, the more compound interest you will 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 saving have already earned.
That example might be beyond our young children, but there are plenty of fun compound interest lessons you might try. 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 fifty 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, ten cents, then fifteen, then twenty) to mimic compound earnings. Our coin discovery activity sheet could help your child track the progress of their savings.
- 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 children save, the more compound interest they can earn.
Information about the “Marshmallow Test”: http://www.webcitation.org/62C0yfhcJ.
How do you teach your children about the time value of money? Share your tips below, and for more financial literacy articles, visit the Beanstalk.