What’s the best way to teach your youngster about saving and the power of compound interest?
Everybody knows you march your kid straight down to the local bank or credit union and open up a traditional savings account. Right? That’s certainly the conventional wisdom.
In fact, opening a savings account for your 6 year old is the “official” wisdom too. So says the panel of financial experts who make up the United States President’s Advisory Council on Financial Capability. It’s item 8 on their list of 20 things kids need to know to live financially smart lives.
My take? That’s complete bullcorn.
Let’s just think about this from a 6 year old’s perspective for a moment:
- I got this awesome $20 birthday check from grandma.
- You marched me down to some random building and left my check there.
- A year later (also known as an eternity to a 6 — now 7 — year old), you told me (if you actually remembered) that I made a penny (if that) in interest. So I now have $20.01 in some fancy “account” that I never see. Big whoop!
- This “savings” thing is a total rip-off. Next time I’m going to tell grandma to just quietly slip me some cash so I can spend it right away before you stuff it in that black hole you call a savings account. Oh yeah, what’s that thing you were calling compound interest? Why is that important again? Oh never mind...
Doesn’t sound too compelling to a 6 year old, does it?
So if a traditional savings account isn’t the right answer for your kids, what is?
Parent-paid compound interest from the Bank of Mom/Dad.
Run your own little mock family bank at home where you define the compound interest offering using amounts and time-frames that are actually interesting to a kid. It’s a technique I first saw described in the book The First National Bank of Dad by David Owen. More recently, the popular personal finance blogger Mr. Money Mustache wrote about the same system in his post: What I’m Teaching my Son about Money.
How does it work? The parent acts as the banker and maintains a pseudo bank account for the child using pencil and paper, a spreadsheet, or an automated online app like FamZoo. The current balance represents how much the parent (the bank) “owes” the child. Mr. Money Mustache describes the day-to-day operations this way:
To make a deposit, he just hands me some cash. To withdraw, he asks me for cash or has me buy something for him online. But for every dollar that remains in the account, he accrues interest at a 10% annual rate with monthly compounding.
That last part is the parent-paid compound interest. Now we’re talking something way more interesting than a penny a year. In fact, Mr. Money Mustache says his 9 year old’s “$600 account is now bringing in a very tangible $5 per month in interest.” Cha-ching!
The awesome power of compound interest will definitely sink in when your kid’s seeing that kind of dough roll in each month. In fact, you may want to cap it so things don’t get too out of control. After all, the Bank of Mom/Dad isn’t too big to fail, which is an entirely different lesson...
Wondering what other parents are paying in compound interest and how often? Here are the average interest rates currently being paid by FamZoo families grouped by compounding period:
- 0.74% compounded weekly
- 2.12% compounded monthly
- 6.51% compounded yearly
By the way, weekly compounding is by far the most popular. 70% of the interest bearing accounts pay interest weekly, 27% pay monthly, and just 3% pay annually. Don’t underestimate the power of repetition when it comes to building a habit.
Whichever compounding frequency you choose, be sure to notify your child (and celebrate) every time an interest payment rolls in. Remember: out-of-sight means out-of-mind; so keep the regular dialog going.
If you keep your little family bank humming for a few years, then someday down the line when somebody asks your grown kid: “what’s the one thing wish you had learned about money growing up?” — the power of compound interest definitely is not going to be the answer like it is for so many adults today. Check out my recent post, 81 Money Lessons Your Kids Will Wish You Had Taught Them 25 Years From Now, and you’ll see what I mean.
You can bet a kid making upwards of a buck a week in parent-paid interest is going to “get” the power of compound interest pretty darn quickly.
And that’s no bullcorn.
P.S. if you’d like to hear an audio version of the parent-paid compound interest concept, check out the short excerpt from a recent podcast below. (Or click here if you’re reading this post in an email.)