Albert Einstein, known for his genius mind, is known to have said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
While some may think of winning big at the lottery or a casino as the easiest way to gain wealth, in reality it is compound interest that has produced the most wealth throughout the world. And the key ingredient that makes it so powerful is TIME. That’s why it’s so important that kids understand this concept at a young age.
EXPLAINING COMPOUND INTEREST
Put simply, compound interest is when you earn interest on both the money you've saved and the interest you earn. For example, when you deposit money into a savings or investment account it earns interest over time. If you don’t withdraw the interest earned from an account, the interest has an opportunity to earn additional interest. The more your interest earns interest, the faster and larger it grows. That’s the miracle of compound interest.
Check out this fun activity using jelly beans to teach kids how compound interest works.
WHY COMPOUND INTEREST IS IMPORTANT
Teens might ask, “Isn’t saving money good enough?” The answer is a resounding no. While the act of saving money is a positive financial skill, saving alone won’t give financial security in the future. That’s because things in the future will cost more than they do today. Compound interest supercharges your savings, allowing it to grow fast enough to keep up with the rising costs of goods and services.
TIME VALUE OF MONEY
The process of utilizing compound interest to build wealth is called the Time Value Of Money. It relies on three ingredients to make money grow, and here’s a secret tip: Your teen has the most powerful ingredient already!
Ingredients for money growth:
Interest is the price a financial institution will pay for your saved money. The higher the interest rate, the more interest you will earn on your savings. Therefore, you should save – or invest – at the highest rate possible, while minimizing risk.
The more money you save, the larger the value of your savings will be. Saving money for the future will always mean giving up purchases in the present. To maximize growth, save as much as possible, as often as possible.
This is the miracle ingredient that teens naturally have more of! The longer they save, the more time their money has to grow. And time outperforms the other two ingredients, hands down. Visualize the power time has on compound interest. Start saving early and save for as long as possible.
Understanding the power of compound interest is the most important financial lesson your teen can learn. This knowledge, along with a little support and encouragement to start saving and investing early, can set them up for financial success.
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The Center for Financial Empowerment is a 501c3 nonprofit organization whose mission is to empower disadvantaged youth through financial literacy education. Find out more about our work.
Choosing To Save, Take Charge Today, August 2013