Three Things I'm Teaching My Children About Wealth

Ellen: Hi, Tom. So, today I want to go over some basics of finance.

Tom: What’s on your mind?

Ellen: As you know, I read all the emails our readers send us. We get so many letters from people who don’t know the first thing about investing. It got me thinking about what kind of basic advice you’d give to a total novice.

Tom: Like what I’d teach my kids?

Ellen: Yeah. Like what are the first three ideas about wealth you’ll instill in your kids?

Tom: I’ve given a lot of thought to that actually, even though my kids are still babies. The very first thing that I want my kids to know is that they are not entitled to money or wealth or anything for that matter, even Christmas presents. They’ll have to earn it. So many people these days think money is an entitlement. You see it every day in the news. But you also see it on the family level. Kids act as if they are somehow entitled to food, toys, video games, and even a roof over their heads. But why should they be? Just because they have parents, it doesn’t mean they should get everything they want…or anything at all for that matter.

So first of all, I’m not going to pay my kids an allowance.

Ellen: Why not?

Tom: Because an allowance would reinforce the sense of entitlement. They can make money by earning it: doing the dishes, making the bed, mowing the lawn...there are a million things. And my wife and I will pay them generously for doing those things. But I’m not going to just give them money.

Ellen: Okay, so are you going to charge them rent, too?

Tom: That’s not a bad idea.

Ellen: Okay, so what comes next?

Tom: The second thing that I want them to learn is the power of compound interest. Just to explain compound interest, let’s take, for example, $100 at 10% interest. At the end of a year, you’ll have $110. During the second year, you’ll earn interest on $110 instead of $100. In the third year, you’ll earn interest on $121…and so on. The numbers get enormous over time, simply because you’re earning interest on your interest.

It’s the only mathematically-certain way I know of to produce a fortune. And because time is the most important element in compounding, it’s an incredibly powerful idea for children to understand.

So, as soon as they’re old enough to understand some arithmetic, I am going to sit down with the classic compounding tables and show them how it works. After that, assuming they have the discipline to follow through, they will get rich. There’s no doubt about it.

But, on the flip side, I’ll also show them that compounding works on debt as well—which is why I hate debt. When you owe money, it compounds because you owe interest. That accumulates on top of the original debt. The debt balloons.

There are two types of people in this world: people who pay interest, and people who receive it. I’m of the latter. I have no debt, no mortgage, no credit cards, and no car payments. And I want it to stay that way.

Ellen: Wow, that’s pretty impressive.

Tom: I don’t believe in spending money that I don’t have. Debt is an expensive indulgence.

That’s the next thing I am going to teach my kids: when you’re pondering a debt, instead of looking at the interest rate (like I think everyone does), you should look at the total amount of interest you will have to pay in dollars over the lifetime of the loan. Once you look at it like that, it suddenly hits you how expensive borrowing money really is.

For example, say you borrow $100,000 with a thirty-year mortgage at 7%. Over thirty years, you'll end up paying $140,000 in interest to the bank. In the end, you’re out $240,000 for a house that cost less than half that. Not a good deal.

Ellen: Okay, but what if you don’t have $100,000 lying around?

Tom: You rent. If you don’t have the money to buy a house, you shouldn’t be buying one. That's the way it is in almost every other country in the world.

Ellen: So are you going to tell your kids that they should, under no circumstances, borrow money?

Tom: The only reason I’d ever use debt is to finance a business or a productive asset. And, I’d only do it if the asset generated a greater return than the debt cost. You could argue a house is a productive asset because it does produce rent if someone lives in it (so I can see how, in that case, a mortgage might make sense). But, I would still never incur debt to finance anything except a business.

Ellen: Anything else to add?

Tom: May I recommend a book?

Ellen: Sure.

Tom: Richard Maybury wrote the best books on finance for beginners I know of. He calls it the Uncle Eric Series. Each book is a collection of letters to his imaginary thirteen-year-old nephew. The whole series is great. It covers history, politics, economics, and law. For finance, I’d recommend Personal, Career, and Financial Security and Whatever Happened to Penny Candy?

Ellen: Thanks, Tom.