Compound interest is the addition of interest to the principal sum of a loan or deposit. It is the result of reinvesting interest, rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
When you deposit your money in a bank savings account, you earn interest. So if you open a savings account with $1,000 and your interest rate is 2%, at the end of the year, you’ll have $1,020, even if you made no other deposits throughout the year.
The next year, if you don’t touch that money at all, you’ll earn 2% on the total balance of $1,020. At the end of the second year, you’ll have earned altogether $40.40.
This repeats over time, gradually earning more interest each year.
By the end of the 10th year, you will have a total of $1,218.
To make it really simple for children to grasp the concept of compound interest, we can use the M&M’s Game to show to them what it really is.
The M&M’s Compound Interest Game:
Give your child one M&M’s. Challenge your child to not eat that M&M’s, and instead hold on to it for just 10 minutes.
If they succeed in delaying gratification and still have that original M&M’s at the end of the time, they get one more. Now you escalate the challenge and the reward.
If they don’t eat either of those M&M’s for another 10 minutes, you’ll add on two more. If they can delay gratification and invest in the “future,” at the end of 20 minutes, they’ll now have four M&M’s.
At the end of the game, explain that this is how compound interest on a savings account works. You leave your money unused in exchange for the reward of making more money. Just as those M&M’s added up, so will their money.