The Magic of Compounding (Explain to me as if I were a 7-year old Series #4)
Iconic thinker Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
Now if we could only start off our children with that lesson early on, maybe we would raise savers and investors for life.
When my sons entered Grade 1, we started giving them weekly allowance that they would put in their treasure box, which was a giveaway they received from their kiddie savings accounts. It was a Sunday ritual we did that excited them. Sometimes they would end up saving their entire weekly allowance because they brought baon to school anyway. They listed down their weekly savings in their small notebook.
Left: Treasure box where they put their allowance; Right: Small notebook where they recorded their savings
Of course when they grew older, they started enjoying the spending more than the saving that they sometimes forgot to save. That made us give them a minimum guideline: 20%. So with that guideline, they immediately set aside no less than 20% of their allowance once they received it on Sunday evening. They did this on all their cash inflows including gifts, dividends and other earnings. It was their initiation to the first basic law of money: Pay yourself First! (Click link to find out more about it.)
Their savings didn’t stay in their treasure box for a long time. Once the savings reached something like P500.00, they deposited it in their savings accounts. Their savings accounts didn’t carry a huge balance because their money ultimately ended up invested in fixed income and stocks.
Explaining the Magic
Using jars and letting your children see them get filled with coins and bills may be an easier way to show them how their money grows due to their disciplined saving habits. However, we went beyond that because we wanted to teach them how to really GROW their money. And it was not going to happen inside the jars.
Our children got exposed to computers way earlier than their parents did. And so it was not going to be a problem to explain to them how the magic of compounding works. I prepared an excel file with various columns – month, deposits, interest, balance. I showed them that if they just save at least 20% of their allowance every week, as they were already doing, they could become millionaires even before they start working.
When they first saw this, they said, “Wow! Really?” And then they tinkered with it, changing the values they could save or the earnings rate and checking how long it would take to reach a certain amount. This made quite an impression on the boys and it helped them continue their habit of saving and investing regularly.
The Third Basic Law of Money
In my book The Retelling of The Richest Man in Babylon the power of compounding is what is being discussed by money mentor Algamish to Arkhad. The former discouraged the latter from using up his savings and its earnings right away. He said, “How can you expect to get rich if you eat the children of your savings? Have an army of golden slaves before you buy luxury!” It is through the third law of money that we can take advantage of the power of compounding.
The Habit goes on. The Magic goes on.
Two of our three sons are already working. Fortunately, they continue to save and invest, no matter what. In fact, since their weekly allowance while in school was on the low side, they were both happy to increase their savings rate once they started earning.
The Flipside of Compounding
There is a flipside to the magic of compounding. And this is something that a lot of millennials and even older ones never really realized until they were deep in credit card debt. It’s the second part of what Einstein said about compound interest.
Inasmuch as compound interest can give you your first million in your teens, it can also bury you in millions of debt if you keep on paying just the minimum amount of your credit card bill. And mind you, since the interest rates slapped by credit card companies are way higher than the return any legitimate investment gives you, then you can get buried in millions of debt a lot faster. So please, pay the total amount of your credit card debts. Do check out your other liabilities which may be causing a drag on your financial well being now.
Credit Card Charges Grade School Style?
One time, my second son Enrique recorded his savings to be P115.00, higher than his entire weekly allowance of P100.00 so I asked how it happened. He said, “My classmate borrowed P5.00 from me last Monday because he ran out of money. He promised to pay me on Tuesday but he did not. Then on Wednesday, when I asked him to pay, he said he already spent all his money again. I was angry so I said if you don’t pay me tomorrow (Thursday), you have to pay me more than P5.00.” His classmate said yes and even volunteered to pay him P20.00 if he would forget again. True enough, he forgot about it on Thursday. But come Friday, my son collected his P5.00 loan plus a hefty 150% interest + penalty for three days! At first I didn’t know how to react. On the one hand, I was thinking, “Don’t allow your son to be a usurer.” On the other hand, I was cheering inside, “My son knows both sides of the Einstein equation on compounding!”
It’s your turn to show the magic!
The excel file showing the power of compounding was a remarkable lesson for my boys. I hope you can use it to encourage your children (and/or yourself) to take advantage of the magic of compounding. Here, click the link below. Change the values of what you intend to save and invest and see how soon you can become a millionaire or whatever desired amount you want to reach.
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Rose Fres Fausto is a speaker and author of bestselling books Raising Pinoy Boys and The Retelling of The Richest Man in Babylon (English and Filipino versions). Click this link to read samples - Books of FQ Mom Rose Fres Fausto. She is a Behavioral Economist, Certified Gallup Strengths Coach and the grand prize winner of the first Sinag Financial Literacy Digital Journalism Awards. Follow her on Facebook and You Tube as FQ Mom, and Twitter & Instagram as theFQMom.
ATTRIBUTIONS: Photos from wpclipart.com, pinterest.com, intrawallpaper.com, 123rf.com, ibtimes.co.uk put together to deliver the message of the article.
