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I recall being taught compounding interest in my early teens and I probably yawned through that lesson.
Like many things I learned through formal education, there was hardly ever a link between the theory being taught and the real world.
First I didn’t understand what the word “compounding” actually meant, and why interest compounding would be useful to anyone.
On reflection, it is clear to me that the many teachers who teach this stuff as part of mathematical theory in schools around the world are themselves running the great rat race.
As a dad to two rapidly growing sons, I often wonder what the future holds for them and what their relationship with money might be like.
Money plays such an incredibly important role in our lives. It's important for our survival just as we need love, good health, personal growth, spirituality, freedom etc.
For those that have made the connection of mathematical theory to our personal financial lives, compounding interest is the safe path to guaranteed wealth that is open to everyone.
Most people think of money in a linear fashion and as such do not appreciate that money multiplies (i.e. interest earned on principal also earns interest and so on).
If money is treated well (i.e. earning a return), then it is really there to work for you i.e. to generate passive income.
However, for this to happen successfully, you need a number of key ingredients:
Time is the greatest of all assets and is the true differentiator of wealth as we will demonstrate later in this post.
Money needs time to work for you, and provided you have placed it in the right environment, it will look after you beautifully.
Warren Buffett accumulated 99% of his wealth after his 50th birthday.
This is because of the beauty of compounding as the snowball effect of income builds up ever greater momentum as time passes.
[yellowbar]Over time, about 80% of your future wealth will likely come from money working for you, and around 20% will come from the original money invested. This is how the rich get richer.[/yellowbar]
This is necessary to keep you on the savings path necessary to add more wood to the fire of compounding.
Most young people today want millions today. This comes at a risk of them really missing the real prize, which is to invest and ride the true asset of time.
If you’re a parent out there and reading this, it’s your responsibility not to let your children become financially illiterate and poor.
Their Financial Independence relies heavily on you passing on knowledge early and making these ideas as real as possible i.e. Commit money to them fast!
Begin taking action today, and a recurring £100 a month invested, for example, will certainly be game changing over time but you will need perseverance to see it work.
The Right Environment
Where your money sits matters a lot, and will determine the extent of your wealth creation over time.
The key is not to save money into a current account and leave it there over time.
Options for investing your money include dividend-paying stocks, index funds or bonds, and with the option to reinvest all your returns.
The choice of environment for your money dictates what return you’ll earn over time. This, in turn, will dictate the extent to which money works for you and your wealth grows.
How To Teach Kids Compounding Interest
Teaching adults the concept of compounding interest is hard enough and is naturally more challenging with children or young adults.
There's also the question of when exactly you start teaching this stuff. My opinion is that children are brighter than adults think and learn very quickly if learning is made practical.
I'd recommend getting them exposed to money as early as possible but ofcourse remember that children are children and any way of making learning fun is encouraged.
The key is to make money and related concepts real and relevant to a child's age and stage of development.
Below are some thoughts on getting kids introduced to the power of compounding interest:
1. The Savings Formula
Developing the habit of savings is really where this journey begins.
It is much easier for children to develop this habit if you can teach them that a proportion of everything that comes into their hands should be put aside.
Saving consistently + Restraint = Future reward
A good way of doing this is to actually physically practice saving money at home.
Children could either have their own piggy banks or save money through the family bank (covered below).
Giving small rewards can further encourage this savings habit.
Saving money is not enough though because they also have to learn that money flows from one place to another and stays where it's looked after i.e. earning a return.
2. Turn it into a Fun Game
I have previously written about the need to make money real.
There is an important need for children to connect with money physically, especially if you can come up with a reward system at home.
A good way to do this is to create a family bank that rewards children above a certain age for various things.
These could include good behaviour, domestic help, excellence at school etc.
For this, you pay them in cash and coins, with an agreement that they have to deposit their money in the family bank.
For putting their money to work in the family bank, you could agree on a monthly rate of interest of say, 10%.
Remember, the point here is for them to see their money work for them, hence the overly generous monthly interest rates.
In the table below, assuming one child had £1,000 of total savings that got invested in the family bank, earning 10% nominal return:
The movement in the interest earned from 100 to 110, 121…to 285 is a demonstration of compounding interest at work.
This could be easily understood by a child/young adult because they won’t have had to do anything more to earn that growth in their money.
3. Make It Visual
One of the best ways to demonstrate the impact of time on compounding returns is to make it visual. The below table comes from the classic Rich Man, Poor Man article, with spreadsheet credit to The Escape Artist.
Consider two investors, Ben and Lucy of the same age but both decide to start investing at different times.
Lucy started investing £2,000 per year through her ISA at the age of 19 for 7 consecutive years only. After those 7 years, she invests nothing till the age of 65.
Total £14,000 invested. Net gains of £930,641
Ben, on the other hand, started late and began investing £2,000 per year from the age of 26, and he carried on investing £2,000 every single year till he became 65.
Total £80,000 invested. Net gains of £893,704
Let's assume they both earn a 10% nominal rate of return.
Now notice the incredible results below. Although Lucy only made 7 contributions and stopped investing, she ends up with a larger net pot of money at the age of 65 than Ben does with 40 contributions!
The 7 earlier years she had invested gave her the edge due to the compounding effect of her money i.e. it had time to work harder for her.
Notice also that her money multiplied 66 times compared to the 11 times Ben's money multiplied for him:
The above chart will make a good demonstration to a child or young adult and will help them connect their actions today with their future.
To conclude, although the points made in this post have mainly focused on children (because they have the benefit of time), everything here is applicable to all adults too.
Time is really the mother of all assets. If understood well and taken advantage of as early as possible, the rewards could transform generations.
How are you teaching your children about Compounding Interest? And that money should work for them one day? Please comment below.
Do please share this post if you found it useful, and remember, in all things be thankful and Seek Joy.