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How to teach your children basic financial concepts

'Sleep on' major money decisions, learn the power of compound interest

By Gary Foreman

The New Frugal You
New Frugal You columnist Gary Foreman
Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website and newsletters. He writes "New Frugal You," a weekly Q&A column about frugal living, for CreditCards.com

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Question for the CreditCards.com expert

Dear New Frugal You
I've always struggled with money. Seems like I every decision I make is bad. We're always short of cash and struggle to make ends meet. My kids will soon be teenagers. I don't want them to learn the hard way like I did. What can I do to prepare them to avoid financial mistakes? -- Concerned Mom

Answer for the CreditCards.com expert

Dear Concerned Mom,
You've asked a very good question, and you're absolutely right. You can make a big difference in your children's lives by teaching them about money and personal finance. In fact, to let them grow up without knowledge in finance is like setting them up to fail as adults. So let's see if we can't help you teach your kids about money.

The first lesson that kids should learn about money is patience. My folks always encouraged us to "sleep on it" before we made any major purchases or decisions. What they meant was that we should give it some time and not rush into purchases.

When I've followed that advice, it's served me well as an adult. I can recall cars that I "slept on" and didn't buy. Other purchases were made, but cost less because I had the time to research alternatives.

Still other items required me to save money to avoid borrowing. By delaying the purchase until I had saved the money, I avoided making payments and the cost of interest owed.

There were times (fortunately few) that I forgot the advice, and my forgetfulness was costly a few times. But, at least they reinforced the lesson that you should sleep on any major purchase or decision.

A second thing that you'll want to teach your children is the power of compound interest. Understanding this concept can make a huge difference in their financial future. Either for their benefit or to their detriment.

What is compound interest? It's all about money multiplying. Let's start with the good side of compound interest. Suppose that you saved $10 and put it in a bank. The bank agreed to pay you 2 percent interest on your savings. So at the end of a year you'd have the original $10 plus 20 cents in interest. If you left it in the bank the following year not only would the original $10 earn interest, but the 20 cent interest from the first year would also earn interest.

That's compound interest.

That might not seem like much, but if you earn 8 percent on your savings (which is a reasonable long-term rate for investments), your money will double all by itself after just 9 years. So without doing anything besides saving the first $10, your money would earn another $10 due to compound interest.

There's a flip side to compound interest. The opposite thing happens if you borrow money. At the end of a year, you'll owe the original loan plus the interest. So any payments you make will first go to cover the interest, and only then will the remainder go to repaying the original loan. Understanding that concept will encourage your kids to begin saving for retirement early. It will teach them to treat debt with respect, knowing how hard it is to repay borrowed money.

You should also teach your teens not to be afraid of accounting and economics. Many adults are. They think that both subjects are beyond the average person. They couldn't be more wrong.

Sure, there are some theories and techniques that only someone with a Ph.D. could understand. But what your kids need to know is fairly simple and can be understood by anyone.

Start with a simple income statement. For a big corporation, it can be difficult. But for you and me, it's simple: just a listing of income and expenses, a way to tell if we're making more than we're spending.

Next, they should be familiar with a net worth statement. That's just a list of the things that you own (assets) minus the list of things that you owe (liabilities). The resulting answer is your net worth. It should be gradually increasing throughout your working years.

Economics are no different. Many of its basic concepts can be grasped by any high school student and many are applicable to their lives. Encourage them to read a basic economics textbook, search for papers on the Web or take an introductory class.

You can also teach financial principles from your experience. Be willing to share your credit card statements so kids see how interest can eat up your monthly payments. Give them an understanding of what your monthly expenses are like. Most teens are pretty clueless when it comes to the cost of living expenses. In short, be willing to share some of the things that you've done right and some that you could have done better.

You've decided to do something very important for your kids. For the rest of their lives, they will be making money decisions. And, in many cases, other people will be trying to get their money. So the lessons that you teach them now will likely pay dividends for the rest of their lives.

See related: 8 financial experiences your kids need to have, Jobs for younger teens 

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Published: December 15, 2011


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