How Can I Explain the Power of Compound Interest to My Teen?

Money0619

June 2019 Issue
by Carrie Schwab-Pomerantz

Dear Carrie, 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? —A Reader

Dear Reader, 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.

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 just for parking your money in an account earning nothing.

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 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.

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.

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 can make it worthwhile.

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. 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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