It’s not about how much money you have to pass on to your kids – it’s about teaching them to be money-wise. Sound financial knowledge can help them make smart financial decisions now, and in the future.
There are key concepts and topics that create a foundation they can build on.
Understanding the Basics
Recent research shows that most of our money habits are developed by the age of seven (1). Yes, the number after six! A parent’s money scripts build the foundation for how their kids feel about money. I hear clients describe an approach they use for their finances based to be based on what they heard growing up. The language and the emotions you use around finances is the one your kids will inherit.
Teaching and including your children directly in day-to-day financial decisions is a great way to directly engage them. They need to be taught the benefits of savings and working through the challenges of instant gratification. Balancing your current desires with your future self is at the heart of successful money management.
An effective way to get started is by teaching them about the difference between needs, wants, and wishes. Here’s an approach that I’ve found to work:
- Sit down with them and have them write down what they would like to spend money on. Next, have them categorize each item as a need, want, or a wish. This can help them understand the differences in day-to-day life. Be prepared for them to ask you if what you’re buying is a need or a want!
- You will want to help them establish their preferences for each item and how much each costs. Then you can help them develop a savings plan that includes a specific timeline.
- Help them recognize and work through opportunity costs. Opportunity cost is the way we weigh the benefits of one purchase or decision versus another. When you’re at the store and they are asking for a toy or a treat, you can reinforce whether that item is a need or a want. Then explain if they get that right now, they will further delay getting the next item on their list.
The Necessity of Budgeting
The next step in building a strong financial foundation is budgeting. In Debt.com’s annual budgeting survey, 98% of respondents agreed that everyone needs a budget – but only 80% of respondents actually have one. This is the highest percentage in the three years of the survey – it’s usually closer to 70% (2). The purpose of budgeting is to help reduce overspending, but it doesn’t stop there.
By implementing a “save, spend, give” system, kids are shown different uses of money beyond spending. Setting up a save, spend, give system can be as simple as labeling three jars or envelopes to act as the respective piggy banks. Every time they receive money whether it be an allowance or a gift, there’s a specified percentage that goes to each of the three categories. I’ve seen a number of families use 20% savings, 70% spending, and 10% giving. (For more ideas check out Ron Lieber’s The Opposite of Spoiled.)
Once they’re old enough to have bank accounts, this same process can also be followed through the use of automated transfers. Typically, banks are able to open accounts for minors once they have reached the age of thirteen as long as a parent or legal guardian signs as a co-owner of the account.
Teaching kids about how to create a budget and the importance of budgeting will not only give them a head start but also helps them develop a habit they’ll hopefully have for the rest of their life. (YNAB is my favorite for adults.)
Understanding Interest
To show children the positive side of interest, rewarding them for saving can help incentivize good budgeting habits. One way to do this is by giving them a small “bonus” every time they put money towards their savings account. Another way to educate them about interest is to ask them if they would rather have $1 million or a penny that doubles every day for one month. Chances are, they will select the $1 million. Now you get to show them the power of compound interest. By taking that penny and doubling it every day for thirty days, the ending balance ends up being north of $5 million (3).
- First Day – $.01
- Tenth Day – $5.12
- Twentieth Day – $5,242.88
- Thirtieth Day – $5,368,709.12
One way to show the negative side of interest may be for the parent to act as their kid’s lender if they don’t have enough money for something. By charging them a little interest, they can begin to see that it’s more expensive to buy something if they don’t have the money for it rather than waiting until they have enough saved.
Diving Deeper into Credit – Building It and Keeping Score
When it comes to credit, an early start helps. It not only can make the transition to independence easier but also highlights the importance of being smart with money. By having built a credit score early, buying their first car or applying for an apartment is easier. This can save not only time but money.
One way to enable kids to start building their credit score is through a secured credit card. They’ll easily recognize how it works for purchases. Better yet is there will be a limit on what they’re able to spend on the card. This helps prevent them running up big balances. Another option that allows for a little more parental oversight is adding them as an authorized user on a parents’ credit card.
A great way to teach the implications of a credit score is to sign up for a free credit service, such as Credit Karma or one offered by your bank. Pulling up your own credit score and walking kids through the different factors that make up the score will give perspective on how much it matters to keep credit balances low and maintain a good payment history. To go a step further, show them the total cost of buying a home or a car with slightly different interest rates. Since personal finance topics start to become intertwined the further you go, this is another opportunity to touch on interest with them as well as the importance and benefits of having good credit.
Creating Commitment with Investing
There are a few ways to get kids involved with investing. A fun way to encourage them to learn about investing is by letting them play a stock market game. There are many different websites and apps that can be used. Kids are given the ability to select stocks in a hypothetical account and manage their own portfolio. The SIFMA Foundation has a great version.
A real-world option is to open a Uniform Gifts to Minors Act or Uniform Transfers to Minors Act (UGMA/UTMA) account. These are custodial accounts that are designed for savings and investing in a minor’s name. This allows both kids and parents to save money into the account while still giving parents control over the account until the child reaches majority age. Both types of accounts can be opened at a bank or a brokerage firm.
The Takeaway
Teaching kids about money is an important role of a parent. Teaching takes time and patience. The knowledge and lessons they learn will stick with them throughout their whole life. It can be tough to educate about personal finance and if there’s anything I can do to make the conversations and lessons easier, I’m here to help.
- Financial Capability of Children, Young People and their Parents in the UK 2016. The Money Advice Service. March, 2017.
- Debt.com 2020 Budgeting Survey.
- Calculation in Excel multiplying each value by 2 for 30 periods.
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