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Monday, January 18, 2021
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The Fin.Lit Corner: Lesson 3 for ages 11-13, compound interest

Mduduzi Luthuli

Most parents excel when it comes to teaching safety and good manners, but with money few know where to start.

Money skills can be a blind spot because so many parents feel financially inept themselves. As a society in South Africa, we don’t talk about money – it’s a massive taboo.

Multiple parents have expressed that they feel money management is an imperative piece of education that needs to be taught while children are still under their care.

In my third lesson about educating children about money, we focus on how to educate children about compound interest. Referred to by Albert Einstein as the 8th wonder of the world.

He who understands it, earns it … he who doesn’t … pays it.

Compound interest is the most powerful force in the universe. The real secret to exploiting compound interest is the sooner you save, the better. As your children approach puberty, introduce the concept of compound interest. How you earn interest, year-on-year, on your investment account.

Compound interest is a difficult concept for even the most financially savvy adults to fully grasp — the idea of our money earning interest, the interest building interest, and so on, is hard to compute.

Now think how challenging it can be to explain compound interest to a child who’s just learning the basics of saving money and financial responsibility. If this puts you in a parental quandary, don’t worry: It doesn’t need to be as complicated as explaining the theory of relativity. It’s basically all about how time affects money’s value. So where do you begin?

First, Explain What Interest Is

“Interest” tends to be a word we take for granted, since we usually haven’t had to explain it to anyone. Keep it simple, especially if your kids are younger: It’s how your savings grow faster the longer you leave them alone. Whatever you save—whether it’s in an investment account, a savings account or a retirement annuity—earns interest not just on what you put in, but also on the money it picks up along the way. The big part about teaching them the value of compounding interest is first teaching them the importance of saving.

Saving over Spending

Once your children are old enough to count, your kids may become exposed to coins and notes in pre-school or primary school, learning that each one holds a numerical value. Take this as an opportunity to demonstrate the discipline of holding onto your money versus spending it. If you always spend your money, you’ll have none left. But if you save your money, you can earn more of it just by holding onto it. The ultimate lesson they should take away is that restraint equals reward.

Time

Compound interest needs time to gain power. And children have a lot of time. A whole lot of time.

The secret is to start your children learning these money skills early and with a simple, age-appropriate system.

Start now because the need for money has not yet arisen. Sure, your children have a lots of wants but their financial needs are not yet separate from yours. This is when you teach them how to make money and how to take care of business. And that means taking care of their money, so it can take care of them for many years to come.

Compound interest with a home piggy bank

Perhaps the easiest way to teach a child about compound interest is to set up a bank account at your home with a piggy bank. Ask them to put a R10 note in it and when he or she does, add R1 of your own. This creates an interest rate of 10%. You might not want to go higher than that, so your child doesn’t get an unrealistic expectation of what he or she will receive in the real world.

Keep track of the account balance on a sheet of paper and using a calculator. Every time your child makes a deposit, calculate 10% of the balance and add that in, rounded to the nearest 10 cents.

Show them the balance at the end of each week or month to illustrate the power of compound interest.

This is a great strategy to teach compound interest and saving for a goal. You can use this strategy to save towards their Christmas gift. Is there a toy or gift your child really wants? Make a deal.

Tell them if they save a certain amount of money, you’ll buy it. Establish at the beginning how much interest they’ll earn on their savings, such as 5% or 10%.

Keeping track

To help kids track their progress toward a savings goal and account for compound interest, keep things visual. Try drawing up a savings goal chart and putting it on the wall. At the end of each week (and especially at the end of each month), mark their progress. Write down how much they have in their savings, along with how much interest they’ve earned.

It is not just earned, it’s also paid.

Another exercise is to teach your kids that interest isn’t always earned; sometimes, it needs to be paid.

Say they want to buy a gift but have not earned sufficient money for the gift.

In this regard, you might want to lend them the money – say, R40 – and create a schedule for them to pay you back R10 over the next four weeks.

Introduce interest into the mix, too, even if it’s a Rand extra a week. If the debt goes unpaid, charge penalties, an extra R2 over and above the R1 per week interest.

This might cause confusion in a child’s perspective:
Why do I need to pay you money when you’re giving me money?
You might explain that when you borrow money from the bank, it’s not free money.
The bank earns its money by charging you extra for the money you borrow.

The workings of interest

Your teen son or daughter may know the basics of borrowing money – that it needs to be repaid – but they may be unaware about how interest works. Think of an example that applies to their life. If they want to save up for a phone, but they don’t have enough money to pay for it, they’ll need a personal loan from a lender. The lender doesn’t make any money by letting you borrow R10,000 and repay the same R10,000; by charging you extra money. They make money, which comes at a cost to you. But then, you also get the luxury of owning a phone before you’ve paid it off.

Create a payment calendar or chart to map the progress. Start lending them larger amounts to build responsibility. It teaches them about interest, and about trust: I’ll promise to lend you this money if you promise to pay me back. But remind them that a real lender or bank won’t be as forgiving if you refuse to repay the money they lend you.

Your children don’t have a credit card yet, but when they do, they will hopefully remember to stay out of debt.

They will one day thank you for this lesson. It’s a life-long lesson every parent should teach.

If you can explain and illustrate the power of compound interest to your children, you are endowing them with the real vision of why saving money is cool.

That when they put money away and leave it to its own mischief, it grows!

Mduduzi Luthuli is CEO of Luthuli Capital, a pan-African investment house that focuses on wealth management

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