The Financial Literacy Test

financial literacy test

Ever wonder how financially literate you are? Take the financial literacy test here and find out! The quiz is from The National Financial Capability Study (NFCS) is a project of the FINRA Investor Education Foundation (FINRA Foundation).

For your convenience, here are the questions:

Financial Literacy Test:

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

a) More than $102

b) Exactly $102

c) Less than $102

d) Don’t know

Question 2: 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?

a) More

b) Same

c) Less

d) Don’t know

Question 3: If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?

a) Rise

b) Fall

c) Stay the Same

d) No Relationship

e) Don’t know

Question 4) True or false: A 14-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.

a) True

b) False

c) Don’t know

Question 5) True or false: Buying a single company’s stock usually provides a safe return than a stock mutual fund?

a) True

b) False

c) Don’t know

Question 6: 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 rate, how many years would dit take for the amount you owe to double?

a) Less than 2 years

b) 2 to 4 years

c) 5 to 9 years

d) 10 or more years

e) Don’t know

Answers to the Financial Literacy Test

Question 1) More than $102

Explanation: You’ll have more than $102 at the end of five years because your interest will compound over time. In other words, you earn interest on the money you save and on the interest, your savings earned in prior years. Here’s how the math works. A savings account with $100 and a 2 percent annual interest rate would earn $2 in interest for an ending balance of $102 by the end of the first year. Applying the same 2 percent interest rate, the $102 would earn $2.04 in the second year for an ending balance of $104.04 at the end of that year. Continuing in this same pattern, the savings account would grow to $110.41 by the end of the fifth year.

Question 2) Less

Explanation: The reason you have less is inflation. Inflation is the rate at which the price of goods and services rises. If the annual inflation rate is 2 percent but the savings account only earns 1 percent, the cost of goods and services has outpaced the buying power of the money in the savings account that year. Put another way, your buying power has not kept up with inflation.

Question 3) Fall

Explanation: When interest rates rise, bond prices fall. And when interest rates fall, bond prices rise. This is because as interest rates go up, newer bonds come to market paying higher interest yields than older bonds already in the hands of investors, making the older bonds worth less.

Question 4) True

Explanation: Assuming the same interest rate for both loans, you will pay less in interest over the life of a 15-year loan than you would with a 30-year loan because you repay the principal at a faster rate. This also explains why the monthly payment for a 15-year loan is higher. Let’s say you get a 30-year mortgage at 6 percent on a $150,000 home. You will pay $899 a month in principal and interest charges. Over 30 years, you will pay $173,757 in interest alone. But a 15-year mortgage at the same rate will cost you less. You will pay $1,266 each month but only $77,841 in total interest—nearly $100,000 less.

Question 5) False

Explanation: In general, investing in a stock mutual fund is less risky than investing in a single stock because mutual funds offer a way to diversify. Diversification means spreading your risk by spreading your investments. With a single stock, all your eggs are in one basket. If the price falls when you sell, you lose money. With a mutual fund that invests in the stocks of dozens (or even hundreds) of companies, you lower the chances that a price decline for any single stock will impact your return. Diversification generally may result in a more consistent performance in different market conditions.

This is why I prefer investing in index funds. More specifically, I love the three-fund portfolio method.

Question 6) 2 to 4 years

Explanation: Ignoring interest compounding, borrowing at 20 percent per year would lead to doubling in five years; someone who knew about interest on interest might have selected a number less than five. Someone who knows the ‘rule of 72’ heuristic would know that it would be about 3.6 years, which makes the correct answer “2 to 4 years.” In finance, the rule of 72 is a method for estimating an investment’s doubling time. The rule number (i.e., 72) is divided by the interest percentage per period to obtain the approximate number of periods (usually years) required for doubling. The other responses reflect a misunderstanding of the concept of interest accrual.

Results

Source: FINRA Foundation NFCS
CorrectIncorrectDon’t Know
Your Results501
National Average31.31.6
   Texas             2.91.51.6

I answered 5 questions correctly but I didn’t know the answer to the last question. The key to this question is the rule of 72.

Of note, the percentage of respondents answered 3 or fewer correct increased by 3% since the 2015 study.

In the 2018 study, only 34% of respondents answered 4 or more correct.

Other findings

In the U.S., 19% of individuals reported that over the past year, their household spent more than their income.

FINRA Foundation NFCS

In the U.S., 46% of individuals lack a rainy day fund.

FINRA Foundation NFCS

This is concerning since you’re in a vulnerable financial situation if you do not have a rainy day fund or an emergency fund.

I just recently learned that a rainy day fund and an emergency fund is different.

Rainy day fund is usually smaller in scope and is reserved for unexpected expenses such as car repair, childcare, or house maintenance. Stash recommended having a rainy day fund of $500 to $1,00o dollars to cover such expenses.

On the other hand, an emergency fund is only reserved for life-changing situations such as short term disability, loss of a job or other factors. The emergency fund should cover at least three to six months of expenses.

In the U.S., 35% of individuals with credit cards paid only the minimum on their credit cards during some months in the last year.

FINRA Foundation NFCS

Final Thoughts

The National Financial Capability Study provides useful insights and provides a glimpse into the personal finance life of Americans. Particularly the data for credit card and emergency fund.

Only 46% of Americans have a rainy day fund, meaning roughly about half is living paycheck-to-paycheck. Coupled with crippling credit card debt, it leaves the average American, not on good financial footing. Trust me, I belonged to the 54% who did not have an emergency fund.

But other data are encouraging, there is an increase in investments in mutual funds. Of interest to me was the higher percentage of millennials utilizing Robo-advisers. According to the NFCS study, 38% of this age group have used the services of a Robo-advisor such as Betterment.

I hope that in future studies, there will be a marked improvement in the financial literacy score. As a matter of fact, the blog exists to document my personal finance growth both in knowledge and in monetary value. I hope that you the young professionals can also improve your personal finance repertoire of knowledge.

How did you did score on the financial literacy test? I hope you aced it!

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