2/3 of Americans Flunked a Financial Literacy Test. Your Bonus Question Here.

Much of the policy talk in consumer credit circles focuses on increasing financial literacy and informed decision-making. The Conversable Economist blog discusses a paper that digs into this subject, called “The Economic Importance of Financial Literacy.” They conducted a 3-question survey “to measure current levels of financial knowledge” among Americans age 50+. Only 34% of respondents answered all three questions correctly:

Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow:

  • More than $102
  • Exactly $102
  • Less than $102
  • Do not know
  • Refuse to answer

Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent per year. After 1 year, would you be able to buy:

  • More than,
  • Exactly the same as, or
  • Less than today with the money in this account?
  • Don’t know
  • Refuse to answer

Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”

  • True
  • False
  • Don’t know
  • Refuse to answer

The first question measures the ability to do a simple calculation for compounding of interest rates. You can go to Investor.gov for a simple calculator and a useful video explaining the concept, or if you want to do it on your own, have at it.

A formula for calculating annual compound interest as follows:

S = P * (1 + j/m)^mt

where

S = value after t periods  
P = principal amount (initial investment)  
j = annual nominal interest rate (not reflecting the compounding)  
m = number of times the interest is compounded per year  
t = number of years the money is borrowed for  

As an example, suppose an amount of 1500.00 is deposited in a bank paying an annual interest rate of 4.3%, compounded quarterly. Then the balance after 6 years is found by using the formula above, with P = 1500, j = 0.043 (4.3%), m = 4, and t = 6.

So, the balance after 6 years is approximately 1938.84. The amount of interest received can be calculated by subtracting the principal from this amount. In this case, you’d have more than $102 dollars.

The second question tests one’s understanding of inflation in the context of a common financial decision. Again, the internet, ie ‘easy button’ way is to go to bls.gov for an inflation calculator (as for the actual formula, stick to the calculator on this one). The main takeaway, however, is that if inflation is higher than the rate of return you’re earning on your investments, your real buying power is actually shrinking. Which means the answer is that you have less than today.

The third question compares stocks and mutual funds relative to risk diversification. Tricky question if you don’t know the basic definition of a ‘stock’ and a ‘fund’. Basically, the point of the mutual fund is to hold shares of many stocks. This spreads out the risk, limiting the upside potential, but also limiting the risk of loss. This was a tough one for many Americans.

And now the BONUS ROUND from Cumulus Funding.

Suppose you had $12,500 of credit card debt, and an APR of 19% (both very common figures for American households). If you pay $250 per month, how much will you wind up paying the credit card company, including principal?

  • Under $12,500
  • Between $12,500 and $25,000
  • Over $25,000
  • I don’t know

Answer: In this case, you will wind up paying the credit card company $25,001.06 ($12,500 of principal and another $12,501.06 in interest). Making $250 monthly payments, this debt will take you 100 months (8 years and 4 months) to fully pay down.

Instead assume you wanted to make the MINIMUM payment each month, and assume this card requires you to pay the monthly interest plus 1% of the principal every month (a common requirement for minimum payments). In this scenario, you would wind up paying the credit card company $31,697.74 ($12,500 in principal and $19,197.74 in interest), and would take you 366 months (30 years and 6 months) to fully pay down the debt.

The following calculators can help with calculating your total payments and the time it would take you to get debt free, depending on if you want to make minimum payments or fixed payments, respectively:

http://www.bankrate.com/calculators/managing-debt/minimum-payment-calculator.aspx
http://www.timevalue.com/products/tcalc-financial-calculators/credit-card-payoff-calculator.aspx
http://www.mymoneyblog.com/financial-literacy-quiz.html

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