Financial Literacy Test

I was recently reading an article on Time that said nearly two-thirds of Americans can’t pass a basic test of financial literacy. That means that almost 66% of people failed the test – I couldn’t believe it! Basic financial literacy? I have a little more faith in our intelligence than that, so I decided to find the actual test itself and take it myself. The test and corresponding survey were done by the FINRA Foundation which self regulates financial markets in the United States. There was some good news from the survey, showing that the amount of people having no difficulty covering their monthly expenses had increased as well as the amount of people who had emergency funds. It also showed that more than half of people who use credit cards pay the balance off each month – the highest percentage since the survey began!

Go ahead and take the quiz yourself if you want before reading my logic going through the question. Warning there are spoilers written just below!

So how did you do on the quiz? I was actually able to get 6/6 questions right, but I think that most people should be able to get 4-5/6 questions right.

Here is how I went through the quiz and my thoughts in coming up with my answers:

  1. Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, how much would you have?

They don’t tell you how often the interest compounds, but for any bank it will compound at least yearly. If you take 2% of $100, that is $2. So after just the first year you have $102. If the interest compounds monthly, daily, etc – you will end up with even more money. Then in the second year you would take 2% of $102 which is $2.04. By the second year you already have $104.04 which is more than $102.

  1. Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?

If you are earning 1% a year but inflation is 2% in that year, you have lost money! Inflation states that the average prices of goods increased 2% for that year meaning the actual value of your money decreased by 1%. Inflation is critical to understand not just to hoard your money under a mattress or in a savings account (more than needed for an emergency fund) so that you are not “losing” money. The answer to this question is less.

  1. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?

The relationship between interest rates and bond prices is inverse. Whatever happens with one, the opposite happens with the other. Therefore bond prices will fall.

  1. A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.

If you think about this one logically, say you have $30 and spread it out over 30 payments – each payment will be $1. If you spread it out over 15 payments, each payment will be $2. If you finish paying off something sooner rather than later, the amount of interest you paying is less. The answer to this question is true.

  1. Buying a single company’s stock usually provides a safer return than a stock mutual fund.

Have you ever heard of the saying “never put all your eggs in one basket”? The same logic applies to this question. It only takes one bad decision to change everything for a company (see: Enron). For the entire stock market? The chances are much lower and this spreads your risk out. One company going bankrupt won’t destroy your entire portfolio. The answer to this question is false.

  1. Suppose you owe $1,000 on a loan and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?

I was personally taught the rule of 72 in college, and I think this is the trickiest question of all of them. To figure out how long it takes your money to double on an investment that compounds annually (a good way to quickly compare multiple investments) is to divide the interest rate into 72. So in this case we do 72 / 20 = 3.6 years. You could have also calculated $1000 * 20% to get 200. Then you’d take $10200 * 20% to get the next year’s interest and so on, until you hit $2000. The answer to this question is 2 to 4 years.

photo credit: no more tests 05.30.09 [150] via photopin (license)

2 thoughts on “Financial Literacy Test

  1. #6: banks compound interest on savings, not on loans. Earning interest on interest is called “capitalization of interest” and is illegal.

    • Good point! I did not realize that, because with student loans interest IS allowed to capitalize and be added to the balance upon graduation. I will leave the post as is though, because that was my thought process for solving the problem. Since the answer was a range of 2 to 4 years, either way of calculating it would have gotten you the correct answer.

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