The earlier we learn financial lessons, the better

But Dad has a tough time teaching compound interest in a low-rate environment

November 27, 2011|By Eileen Ambrose, The Baltimore Sun

John David Kromkowski learned about compound interest as a youngster with the help of a passbook savings account at the bank.

"Every time you went in, they would calculate the interest for you and put it in the book," the 49-year-old Baltimore County lawyer recalls. "It made me feel like, 'I'm making money here.'"

Now, Kromkowski wants his son to learn about the miracle of compounding — earning interest on interest. The problem: Savings accounts pay so little interest now that compounding is negligible.

Kromkowski's son, Simon, deposited $500 a few months ago that he inherited into a savings account with Bank of America that pays an annual rate of 0.04 percent. The first month's interest: one penny.

According to urban legend, Albert Einstein declared compound interest the greatest invention in history, but Simon so far isn't impressed.

"I think it's kind of stupid. You put lot of money in it, but you don't get anything," the 11-year-old says. "I can't buy anything with one cent."

This doesn't mean parents should give up on a lesson about compound interest or not bother to open a savings account for a child.

Compound interest is an important concept, and the earlier it's learned, the better. Money you put away in savings earns interest that is added to the principal. Then you earn interest on that, causing savings to build faster.

Compound interest, though, works against you when you borrow. Interest accrues on the debt over time, and you can end up owing much more than you borrowed.

Savings accounts also remain a valuable teaching tool, despite today's dismal interest rates. Children with bank accounts can learn to become disciplined savers by watching their balance grow with each deposit. Indeed, some of today's top financial minds learned money basics through a childhood account.

Brian Rogers, chairman of the Baltimore-based investment firm T. Rowe Price, told me years ago that he developed the savings habit from a passbook savings account that his parents opened for him when he was 6. The bank for years paid a rate of 5 percent, so compound interest was easy for the young Rogers to see.

Rogers, 56, held onto the account for decades — partly for sentimental reasons — but closed it this year when the bank was acquired.

Financial experts suggest parents explain to kids that these are highly unusual times of very low rates. And banks and credit unions that visit schools to teach about finances point out that some interest is better than none at all.

"We tell students the secret to getting rich slowly … is the miracle of compound interest," says Lisa Monthley, chief deposit officer with New Windsor State Bank in Carroll County.

Students usually have piggy banks, Monthley says, and the amount in there today will be the same many months from now if left alone.

"If you put it in the bank, it will earn interest and compound over time," she says. "And if you leave it alone and add to it, you will slowly get rich."

Still, Monthley sympathizes with Simon.

"We all feel the same way," she says. But at least, she adds, he is earning some interest and his money is secure in the bank.

Here are a few tips for parents wanting to teach the value of compound interest:

Shop around You're not going to find a financial institution paying a generous interest rate, but you can find places that offer more than 0.04 percent.

Credit unions, for instance, tend to offer higher rates on deposits than banks. You can also find more generous rates at institutions farther away if you're willing to bank online.

Sallie Mae Bank, for instance, offers savings accounts with an annual percentage yield of 1 percent that's compounded daily. On a $500 deposit, the balance would grow by $5.03 the first year. Not much, but better than the 20 cents that Simon will earn.

Check Bankrate.com to find out the highest rates on savings accounts being offered in your city or nationwide.

Or consider putting money in a certificate of deposit, in which the rates are higher. The drawback is that money will be tied up during the term of the CD and you will forfeit part of the earnings if you withdraw the cash early.

Parents as bankers The experience of seeing a savings account grow with interest has a powerful impact on children, says Lew Mandell, a financial economist with an expertise in children's financial literacy. But if banks won't provide that experience, parents can do so themselves, he says.

Mandell suggest that parents pay the interest, depositing the money quarterly in the child's savings account. It doesn't have to cost much, he says. At 3 percent annual rate, parents would pay out a little more than $15 the first year on a $500 initial deposit.

"To make it more interesting, think of giving the child 5 percent a year," he says. At that rate, parents would pay about $25.50 the first year. After 10 years, the child's account would grow to $821.81.

When higher interest rates return, Mandell says, parents can stop playing banker.

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