5 lessons to teach kids how interest works

While your kids may readily grasp the concept of putting money aside for a rainy day, getting them to understand how interest can add to their wealth or leave them drowning in debt may require more novel explanations.

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Try comparing interest to the idea of renting, suggests Elisabeth Donati, owner of Creative Wealth International, a Santa Barbara, Calif., company that holds financial summer camps for children. The next time you rent a movie tell them, "We had to pay a rental fee in order to use this video. When you put your money in the bank, the bank pays you a rental fee to use your money," Donati explains.

Here are five exercises you can use to make the concept more real for your kids.

Lesson No. 1: Reward savings
Children learn financial principles not only by hearing, but by doing, says Tiffany "The Budgetnista" Aliche, author of "The One Week Budget," and a developer of financial literacy programs for kids. While an allowance gives kids money to be responsible for, it can also teach them about interest.

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Have your child set a predetermined percentage aside from his or her allowance each week that will be considered "savings." For example, if a child receives $10 per week, have him or her save 10 percent, or $1 a week.

Explain that you will add a quarter (or nickel or dime) in interest to their savings each month for every dollar they save. The more money they save, the more interest they earn.

Throughout the month, have the child track how much he or she contributed to savings. At the end of the month, count the total amount in savings together, which will include the amount of money saved plus the interest earned. Once the child understands the concept, let him or her open a savings account at a bank to continue to amass interest.

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Lesson No. 2: Make a loan pay off
To help children learn that borrowing money is never free, Aliche suggests using an exercise that her father did with her when she was a child. "My dad used to give us an allowance and then borrow money from us," says Aliche. "Then he would pay us back with interest."

To do this exercise, wait until your child has a little money saved up. The amount you "borrow" should be relative to what the child has saved. For example, if your child has saved up $20, you might ask to borrow $5.

Keep the money for a couple of days. Then thank your child for lending the money and tell him or her that you are ready to pay it back. When you pay it back, you'll give the child 10 percent extra. So if you borrowed $5, you'll pay back $5.50.

At this point, explain to your child that the 50 cents is what it cost for you to rent or borrow the money. After you do this exercise a few times, don't be surprised if your child understands the concept too well. "One of my sisters would eventually haggle with my dad for a higher interest rate, telling my father she wanted 20 percent," Aliche says.

Lesson No. 3: Become the lender
Before you teach your children about the costs of using credit, make sure they understand the concept of getting a loan and having to pay it back. Michelle Oliver counsels those in financial trouble through her work as a financial adviser at Virginia Asset Management in Richmond, Va., so she often looks for teaching opportunities to make sure her 10-year-old daughter Lauren and 6-year-old son Evan learn the realities of debt.

Oliver suggests choosing an opportunity when a child wants something, but doesn't have the money saved up.

Offer to loan the child the money, but prior to purchasing the item, lay out the terms. "You might say, 'You wanted me to give you the money to take you and your friend to the movies and it cost $20. So let's do a payment plan over the next four weeks. You get $20 a week in allowance so now I'll give you $15 for the next four weeks,'" says Oliver.

Use a calendar or create a chart that tracks the child's progress so he or she can see how long it takes to pay the debt off.

Once the child understands the concept of paying loans back, add interest to the mix, charging the child, for example, an extra dollar for each week the debt is not paid in full.

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Lesson No. 4: Show, don't tell
One of the best ways parents can introduce kids to credit cards is to show them a family credit card bill, particularly now that credit card statements show the amount of time it will take to pay the balance off. 

"You want to teach children how you will have to work doubly hard to pay off what you owe with the high interest rates credited every month," says Audrey Tan, co-founder of PlayMoolah, a company that creates financial literacy products and online contests for kids.

For older children in their teens, get a sales paper and have the child create a chart listing items along with their prices. Then create three more columns, and figure out how much the items would cost if you added 10 percent in interest each month for the next three months.

"Keep track of prices of items with interest rates accruing over time and watch how expensive your items will become," says Tan. "Then ask the child, 'Can you wait for a longer time and pay less and still get the same item?'"

Lesson No. 5: Give them credit card power
Arm your child with an index card that details how much money he or she can borrow from you and what the terms would be for the child to pay you back. You might say the index card is worth $30 and the child would have $5 per week taken out of his allowance until the debt is paid off. To simplify the concept of interest, you might also say that the child will have to pay an additional $1 for each week that the debt is not paid in full.

When the child elects to use the card, don't try to talk him out of the purchase. However, make sure you enforce the terms, which teach the ultimate lesson: "When you use something that's not yours, you have to repay the person in some way," Tan says. "You will have to pay back a little more than you borrow, so that means you need to have more money in the future to do so."

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