Financial literacy is often overlooked when preparing young adults like college graduates for the real world, yet it is one of the most valuable tools you, as a parent, can equip them with. As they begin to earn an income, they will face important decisions about spending, saving, and investing, and these choices can quickly become overwhelming. However, the choices they make in their early adult life can have a lasting impact on their financial well-being. Understanding the concept of compound interest as they begin earning an income and starting their career will directly impact how their investments grow over time. Explaining this concept in a way that resonates with them can set them up for a secure financial future and empower them to make better financial decisions. Here’s a simple yet effective way to break down compound interest for your young adult.

Start with the Basics

First, explain that interest is the cost of borrowing money or the reward for saving it. When you borrow money, you pay interest to the lender and when you save money, the bank pays you interest as a reward for saving. There are two types of interest: simple interest and compound interest. Simple interest is calculated only on the initial amount of money you deposit or borrow, while compound interest is calculated on both the initial amount and any interest already earned or accrued. The frequency of compounding (daily, monthly, or annually) also plays a role in how quickly your money can grow.

Illustrate with a Real-Life Example

Let’s say your child earns $150,000 per month from their first job and deposits 10 per cent (or $15,000) in a savings account each month, totalling $180,000 annually, with a 5 per cent annual interest rate. Assuming no withholding tax for simplicity, with simple interest, they would earn $9,000 every year, the amount grows steadily but it is only based on the initial $180,000. Now, with compound interest, after the first year, they would still earn $9,000 in interest, bringing their total balance to $189,000. However, in the second year, the 5 per cent interest is applied on the new balance of $189,000, which means they would earn $9,450 in the second year, bringing their total to $198,450. Over time, this “interest on interest” effect grows their money faster than with simple interest. The difference between simple and compound interest becomes significant, showing the true power of compounding over time.

Make It Relevant and Highlight the Power of Time

It’s crucial to relate this concept of compound interest to your children’s future goals. Explain that compound interest is not just for savings accounts but also applies to various investments like stocks, bonds, and retirement accounts. When they earn returns, whether in the form of dividends, interest, or capital gains it is important to reinvest those returns so that it can compound over time. Additionally, parents should emphasise the importance of starting to invest early. For example, if they start investing $10,000 per month at age 20 with an average annual return of 7 per cent (a typical return for many investments), by the time they are 60 they could accumulate around $24 million. If they wait until age 30 to start investing the same $10,000 with the same 7 per cent annual return, they would end up with about $11 million by age 60. Even though the monthly investment is the same, starting at age 20 can lead to significantly more money in the long run because compound interest has more time to work. The key is to invest early, and often, in order to maximise the benefits of compound interest. It’s like planting a tree; the earlier you plant it, the more time it has to grow into something strong and fruitful.

Encourage Action

Finally, encourage your child to take action by opening an investment account and start contributing regularly, even if it’s just a small amount. Remind them that the key to harnessing the power of compound interest is consistency and patience. Every dollar invested today is a step toward a more secure financial future. Encourage them to set up automatic contributions to make investing easier.

Compounding Also Applies to Debt

While compound interest can significantly boost investments, it’s crucial to help your children understand that it can also affect them when they take on debt. Just as compounding can grow wealth, it can also cause debt to increase rapidly, particularly with high-interest loans. Therefore, it is important to educate them about the type and purpose of loans they take on. Essentially, understanding how the power of compounding interest impacts both investments and debt will help ensure that borrowing is used wisely to support financial growth and stability, especially early in their careers.

Bottom line

Understanding compound interest is a game-changer for anyone’s financial future, especially as your children begin their careers. By breaking down the concept into simple terms and connecting it to their personal goals, you can help them appreciate the value of saving and investing early, as well as the importance of using and managing debt wisely. With this knowledge, they’ll be better equipped to make smart financial decisions that will benefit them for years to come. Encourage them to start taking action today — whether it’s opening an investment account or simply setting aside a small amount each month. While you can provide a strong foundation, you can’t teach them everything, therefore, encourage them to continue their journey to financial literacy. For expert advice on how they can align their investment strategy with their financial goals, advise them to contact an NCB wealth advisor who will connect them with the resources needed to secure their financial future.