Financial literacy for teens: The power of compound interest

Imagine saying to your teen, Hey, let’s sit down and talk about financial stewardship! Would you be met with eye rolls? Would your teen invent an excuse to bolt out the door?

So many parents face that kind of dilemma. Having covered tithing, saving and spending within a budget at some point in the past, parents have a sense that it’s time to teach their 16- or 17-year-old more about careful financial management.

But how do you get a teen to stick around long enough to have that conversation? And what should you talk about anyway?

If your child is in their mid-teens – and especially if they already have a part-time job – introducing your child to the power of compound interest can be a good place to pick up the conversation about managing money again. And here’s why:

Firstly, for the wow factor! The extra money generated by compound interest in a long-term savings plan makes for an impressive demonstration that’s sure to get your teen’s attention. Who knows, maybe it’ll turn a teen who’s a big spender into a saver!

Secondly, understanding compounding interest will prepare your teen for an important follow-up conversation you’ll want to have later: a discussion about the hazards of using credit cards and taking on other kinds of debt. Kids absolutely need to understand how interest on any debt they incur will work against them.

For now though, you’ll want to start with something super exciting and positive: how compound interest can be a big boost to savings. And this article, we hope, will help make the conversation easy for you. It’s written in the form of a letter that you can alter in any way that suits you, then hand over to your teen.

Yes – a letter sounds so old school! But it has the benefit of giving your child time to come to grips with the basic ideas and simple math at their own pace. There’s no fear, for your child, of looking foolish if they don’t catch on right away – as can happen in a face-to-face conversation.

Hopefully your child will have questions after reading the letter through, jump-starting some great follow-on conversations.

Have fun making your own version of this letter, and in guiding your child to a more advanced understanding of financial stewardship!

(And don’t miss the video at the end of this page that may prove helpful once your teen has had a chance to absorb the information in your letter.) 

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A letter for your teen about super-sizing their savings via compound interest

Wow! You’re 16 now! I can hardly believe it. I see you maturing and taking on more and more responsibility, and I’m so proud of you.

You’re starting to build a stash of your own money too. That’s got to feel good!

I’m sure there are things you really want to buy with your money, and that’s okay. Those choices are up to you. My purpose in writing this letter is simply to give you some pointers on how to manage your money well.

This is a lot to lay on you but the truth is, what you do with your money right now, while you’re young, will have a huge impact on what your lifestyle will look like later in life – whether you’ll be enjoying financial blessings, or whether you’ll be saddled with debt and stress.

That’s why I want to show you how you can use a little of your money now to make even more money in the future – a lot more money. 

Many adults know these principles about how to super-size their savings, but they leave it too long to act on them. They miss out on free money they could have made if they had started saving some of their income when they were younger.

You, on the other hand, have the most important thing you need, and that’s plenty of time ahead of you for your money to grow.

I’m setting all this out in a letter so you can think over what I’m about to explain. I know you’ll have lots of questions, but this seemed like a good way to get the conversation started.

Before we get into details however, please hear me on this: 

I’m starting this discussion about finances with you because I think you are ready to understand these adult concepts. I certainly don’t want you to become obsessed with making money for its own sake. 

We were not created for greed, to serve ourselves. We were created for God, to love and serve him, and to love and serve others. Jesus called these the two greatest commandments (see Matthew 22).

Let’s take a quick look at God’s purposes for money . . .

From hundreds of verses in the Bible that reference money or possessions, we know that God wants us to:

• Give at least 10 per cent of our income back to him (our thanksgiving for all God’s blessings to us)
• Save enough to take care of our needs and the needs of our family in the future (keeping in mind that illness, injury or some other disability will make this difficult for some people)
• Avoid unwise debt
• Always be generous toward others.

So is God okay with the idea of using your money to make more money? Yes he is, as long as your motive is not greed, but to wisely plan ahead for your financial future. He approves of slow, steady saving (Proverbs 13:11, Proverbs 21:5) and providing for your family (Matthew 15:1-9, 1 Timothy 5:8). 

Unfortunately, many Canadians wait too long to get serious about saving, and they realize, too late, that they won’t have enough to live on in their retirement. The very best time to get serious about saving is early in life, when the money you save has lots of time to earn extra money for you.

How to put your money to work

When we talk about using money to make more money, what we’re really talking about is investing. 

Investing is not the same as putting your money in a regular bank account (such as a savings account or a chequing account). A chequing account – or even a savings account – is a good place to keep money that pays for all your regular expenses, like bus fare or your phone bill. You need quick access to that money. It flows into your account on payday, and it gets spent again really quickly.

But do people keep their long-term savings in these kinds of accounts? No way! That’s because the amount of interest you earn on a regular bank account is very, very small – almost nothing.

(By the way, do you know how interest is earned? When you put your money in a bank or some other financial institution, it doesn’t just sit there for safe keeping. The banks lend your money out to others who want to borrow some cash. But the borrower has to pay back extra money as a fee for loaning the money – that’s called “interest.” The banks give a little bit of that interest – some bonus cash – back to you, as a thank you for letting them loan out your money.)

As I was saying, no one uses a regular bank account for their long-term savings because the interest rates are so tiny.

To get serious about saving, you need some type of investment account. 

An investment account can make you a significant amount of money, over the long term, thanks to the power of compound interest.

When you have compounding interest working for you, the amount of bonus cash you earn each year in interest doesn’t stay the same. That cash bonus – the interest you earn – keeps getting bigger and bigger every year.

Compound interest – your superpower! 

Compound interest is important to understand, because it’s the superpower that gets your money earning more money for you – provided you leave your money invested for a long time. The easiest way to explain it is to show you some simple math. (It’s not hard to grasp, I promise!)

Here are two different scenarios:

First scenario (without compounding interest): 

Imagine you put $100 in an investment account that earns you 8% interest per year.

• At the end of year 1 you have earned $8 in interest. Now you have $100 + $8 = $108.
  
  Imagine that, in this scenario, you don’t know about the power of compound interest, so you decide to withdraw that $8 you earned in interest and spend it.
  
  
• At the end of year 2 you start again with $100, so you earn another 8% interest by the end of the year. Once again you have $100 + $8 = $108.
  
  But once again you decide you spend that $8 you earned in interest.
  
  
• If you keep withdrawing your interest portion and spending it, at the end of 20 years you will have $100 – the same amount you started with.

Second scenario (with compounding interest):

Imagine that this time, you start out the same: You put $100 in an investment account that earns you 8% interest per year.

But in this scenario, you decide to not to withdraw any of the money so compounding interest can work its magic.

• At the end of year 1 you have earned $8 in interest. Now you have $100 + $8 = $108.
  
  
• At the end of year 2 you started with $108 so now the 8% interest you earned is not $8, but $8.64. Now you have $108 + $8.64 = $116.64.
  
  
• At the end of year 3 you started with $116.64 so now the 8% interest you earned has increased to $9.33. Now you have $116.64 + $9.33 = $125.97.
  
  
• At the end of 20 years, you will have $466.10. Your initial $100 became $466.10 because you gained $366 of extra money in interest.

Big whoop, you might be thinking, I can see how compounding interest works but that still doesn’t sound like a lot of money.

Agreed, it’s not very impressive if you only ever invest $100 for your future. 

But look what happens if you invest more: 

Let’s say you start with $1,000 in that first year and keep adding $1,000 to your investment account every year after that.

After 20 years, if you let compounding interest do its work, you will have contributed $20,000 but the total amount of your investment will be over $49,422. You’ve more than doubled your money!

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Catherine Wilson is an associate editor at Focus on the Family Canada.