Westport News: Explaining Interest to Your Child

How does a parent explain the theory of interest to a young child? And what is the difference between earning interest and paying interest?

I realize that even adults don't always grasp these concepts. While it is a struggle to think of simplistic ways to explain these concepts to your children, I have come to the conclusion that it is better to show them, rather than tell them, about this financial term.

An easy way to help your child understand this concept is to take them through an exercise. On Monday, have them add a penny to a clear jar every day. Make it part of the morning ritual that they take a penny, throw it in the jar, and then write down on a piece of paper the day recording the deposit. At the end of the week (seven days), bring the jar with the seven pennies in, plus two more that you add, into your kitchen for a discussion.

If you haven't caught on yet you are playing the role of The Bank of Mom & Dad.

Have them dump out the pennies on the table and count them. You will inevitably get this question, "How come I only put seven pennies in the jar and now there are nine?"

You will explain to them that this is what's known as "interest." When you deposit your money in the bank, they pay you money so they can use it while you're not. While they're not using the money, it is making money for you.

The next question to ask your child is, "How do you think the bank can afford to give you free money?" Be prepared to get some funny answers to this one. Remember; don't stifle your child's thought process by shooting down their answers. A parent can have fun responding by saying, "Well, that is good thinking but I wonder if there might be another reason we can think of."

Ultimately, you'd like to get to the answer that the bank is lending out your money to other customers, who are in turn paying the bank for the use of that money (the money that was originally yours). In fact, act this out. Take the seven pennies and hand them to someone else sitting at the table. Make them return the seven pennies with seven more as interest. Then hand nine of those 11 pennies back to your child, leaving you (remember, The Bank of Mom & Dad) with two extra pennies, which are your profit.

You can see in this fairly easy exercise that you have covertly taught your child the concept of earning interest and also borrowing interest costs at the same time. And one of you will have a child astute enough to ask you, "Why would I give my money to the bank when I could just lend it to someone else and make four pennies instead of two?"

And when you hear this entrepreneurial comment, your child has taken a major step on the path to financial literacy.