How Can I Explain the Power of Compound Interest to My Teen?
The power of compound interest is one of the best reasons to start saving early. Because you earn interest on your interest, once you set it in motion, it takes on a life of its own.
The flipside of saving and growing your money through compounding is what you lose by not saving.
The same concept applies to investing—with an even greater potential for growth over time.
My 17-year-old daughter has her first summer job with a reasonable salary. To me, this is a great opportunity for her to start saving and realizing the power of compound interest. What’s your advice on how to explain that to her?
I agree this is a great opportunity for your daughter to start saving—and the power of compound interest is one of the primary reasons as you suggest. A key factor in compounding is time, and at 17 your daughter has plenty of time to watch her savings grow. Plus, while interest rates have been very low for the past 10 years, they're starting to rise and that can help even a beginning saver see some results.
This simple concept of compound interest can sometimes get lost in more complex discussions about investing, but whether you're a saver or an investor, compounding is one of the most powerful engines that drive returns over time. So I appreciate the chance to focus on this essential topic. The challenge for you, of course, is how to get your daughter engaged.
Let the numbers speak for themselves
Basically, compound interest makes your money grow faster because interest is calculated not only on the principal but also on the accumulated interest. To me, one of the great things about compound interest is that it can grow your money automatically. Because you're earning interest on your interest, it takes on a life of its own—even if you never add another penny to your principal.
The best way to get your daughter's attention would be to show her some numbers. Start by using a realistic interest rate for a savings account today. Let’s say you put $10,000 in an account earning 2.25 percent. After 10 years, you'd have $12,492—25 percent more than you would get just parking your money in an account earning nothing.
Go through some savings scenarios
Of course, it would be unusual for a young person to start with a $10,000 nest egg, so it's also important to demonstrate how saving a small amount of money on a regular basis can lead to similar results. Here's an example your daughter may be able to relate to: Let's say she saves $50 a month for 10 years and never earns any interest on it. At the end of that time, she'd have $6,000. But if she earned 2.25 percent interest, she'd have about $6,700 at the end of 10 years—or about 12 percent more.
To give her an idea of what's possible, use an online savings calculator and go through different scenarios. Play with contributions, interest rates and timelines to see how the numbers add up. This can be a good motivator demonstrating how the earlier she starts to save—and the more she saves—the more impressive the numbers.
Talk about the cost of NOT saving
The flip side of the story is what you lose by not saving and earning interest. That's called opportunity cost—the loss of the benefit if you choose to do one thing, for example, (spend) instead of another (save).
To make it real, this would be a good time to talk about her goals, both short and long term. Whether it's a trip, a car or college, the more time she has to save, the better. By forgoing an expensive night out or an extra pair of shoes, she could eventually get something that means more to her. It doesn't take a huge commitment, it just takes getting started.
Help her open an online savings account
Experience is the best teacher, so help your daughter open a savings account. Right now, online banks are offering the highest interest rates, so that's where I suggest you start. Compare accounts, looking at fees and services such as ATM access and direct deposit, as well as interest rates. NerdWallet and Bankrate are both good sources of information.
Ideally, she could set up a monthly automatic deposit from her checking to her savings account. The more automatic she makes it, the easier it will be to get into the savings habit.
Saving is just the beginning
The first step in growing your money is saving. The next step is investing. And this is where compounding can really make a difference. While savings accounts are a safe place to put your money, earnings over time are generally lower than what you can potentially get by investing in other types of asset classes, like stocks or bonds. On the other hand, while investing includes more risk, the potential for higher returns—especially over time—can make it worthwhile.
Let's take that $10,000 example and this time use a rate of return you might expect for a moderate stock portfolio: Invest $10,000 for 10 years with a 6 percent annual return and you'd have about $18,000 or almost 80 percent more!
To help your daughter get investing experience, you could open a custodial brokerage account for her or even help her open a Traditional or Roth IRA since she now has earned income. Once she has enough saved, she could buy a few shares of something like a broad-based stock mutual fund or exchange traded fund (ETF). Yes, retirement is a long way off, but here's another example that might catch her attention: If she invested $1,200 a year—only $100 a month—between now and age 66 and earned a 6 percent annual return, she'd have about $357,333!
Of course, time is a key factor in the power of compounding. And, according to Warren Buffet, who attributes much of his success to compound interest, it's also about patience. At 17, your daughter has the gift of time. Now, if she can consistently save and patiently watch her savings grow, she'll be giving herself the gift of financial security as well.
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