86% of Americans cannot answer these basic financial questions. Can you?

Below is a simple 5 question quiz presented to 25,000 Americans, and only 14% got all 5 answers correct.

 

This is troubling because not understanding these topics can have a profound impact on your future investing success.

 

A lot of families handle their own finances, so it is imperative that the basic topics covered here are understood. At Begin To Invest, I want to empower people to have the confidence to handle their own finances and be able to do it well.

Here, we discuss the topics covered in the 5 question quiz in detail, to ensure you understand these concepts.

 

The quiz can be found here. The questions, answers and discussion of the topics quizzed are also found below:

 

How many can you get?

 

The Questions (Answers below):

 

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

 

 

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

 

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

 

4) True or false: 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.

A)     True

B)      False

C)      Don’t Know

 

5) True or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.

A) True

B) False

C) Don’t Know

 

 

Answers:

 

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

 

The Correct Answer is more than $102.

 

This question deals with the idea of compounding interest.

 

At the end of the first year, you earn 2% on your $100 in principal, or $2. This brings your savings account up to $102 dollars. At the end of the second year, will you just earn another $2?

NO, in fact you earn more than $2 because you also earn interest on the $2 you received at the end of the first year. You get a 2% return on $102, not just $100. This makes your total $104.04 at the end of the second year.

 

How do the numbers look at the end of the 5 years?

 

Year

Savings Total

1

$102.00

2

$104.04

3

$106.12

4

$108.24

5

$110.41

You make an “extra” 41 cents due to compounding interest.

Although the amount is small, compounding interest does really add up when you consider 30+ years (the amount of time you will be saving and investing for retirement) and dealing with larger amounts of money.

 

Take a look at what compounding interest means for a 25 year old investor over time who invests $5,000 with a 7% return:

 

Year

Savings Total

1

$5,100.00

2

$5,202.00

3

$5,306.04

4

$5,412.16

5

$5,520.40

6

$5,630.81

7

$5,743.43

8

$5,858.30

9

$5,975.46

10

$6,094.97

11

$6,216.87

12

$6,341.21

13

$6,468.03

14

$6,597.39

15

$6,729.34

16

$6,863.93

17

$7,001.21

18

$7,141.23

19

$7,284.06

20

$7,429.74

21

$7,578.33

22

$7,729.90

23

$7,884.50

24

$8,042.19

25

$8,203.03

26

$8,367.09

27

$8,534.43

28

$8,705.12

29

$8,879.22

30

$9,056.81

One Time Investment - Compounding Interest

 

This example begins to show the power of compounding interest. Over time, a single $5,000 with a 7% return becomes $9,000!

 

But the beautiful thing about compounding interest is how adding just a little bit more time and money into the equation really adds up. Take a look at what happens if you invest that $5,000 EACH YEAR for 30 years:

 

Repeat Investment - Compounding Interest

 

 

Although you “only” saved $150,000 over those 30 years, you end up with over $450,000! That is the power of compounding interest.

 

This is why the power of compounding interest is something that you MUST UNDERSTAND.

It is why investors need to start early, no matter how much they can afford. Because over time, even small amounts of money can really grow.

To see more examples on compounding interest, and why it is important to start saving when you are young, see our post here: “How much do I have to save to get a million dollars – $1,000,000?

 

 

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?

 

The correct answer is Less.

 

Inflation is the loss of your money’s purchasing power. The Federal Reserve aims to keep inflation around 2-3%. That means your cash sitting in your bank account losses 2-3% of its purchasing power each year. Although in the example above, you are getting a 1% return on your savings account, the dollars are buying 2% less. Even though you will end the year with more money in your account, the amount that your savings account will buy is actually decreased.

 

This is why knowing how to invest is so important. You cannot save enough for retirement by just holding cash, you need to generate some type of return to beat out inflation so that your money continues to have the buying power decades down the road.
FINRA explains inflation this way:

 

“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.”

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

 

The answer is that bond prices will Fall.

 

Bond (or stock) prices have an inverse relationship with interest rates (or yields).

 

Right now, you can buy a 10 year Treasury bond that yields about 2.17%. When you buy that bond, you are “locking in” your money at a 2.17% return for 10 years.

 

Let’s say 5 years from now, interest rates rise to 5%. Who would want to buy a bond yielding only 2.17% when they could buy a bond that yields 5%? Therefore, the price of the 2.17% bond will fall.

 

For a much more detailed discussion of the relationships between bond and stock prices and interest rates and yields, look at our Yield Definition Page.

 

Its also important to note that an investor who holds the bond until it matures, all 10 years in the example above, does not lose any money. They will receive interest payments from the bond for 10 years, and at the end of the 10 years receive their principal back in full. However if they decide to sell the bond on the secondary market before it has matured, they may face a loss.

 

FINRA explains:

 

“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.”

4) True or false: 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.

 

The correct answer is True.

 

 

For a comparison, take a look at a mortgage calculator for a basic $200,000 loan at 5% interest.

 

 

15 Year Mortgage:

15yr mortgage calculator

 

30 Year Mortgage:

30yr mortgage calculator

 

15 Year

30 Year

Monthly Payment

$1,582

$1,074

Total Interest Paid

$84,686

$186,512

Total Loan Cost

$286,260

$387,580

 

 

30 year mortgages are popular because of the lower monthly payment, but take a look at how much more the loan costs you over the course of the loan! Over $100,000 more!

 

This is an example of compounding interest working against you. For the same reason that investing a little bit now is important (because it grows so much over time). Paying down debt early is important, because over time the payments and interest really add up!

 

A 15 year mortgage costs more each month, because you must repay the principal ($200,000) in 15 years instead of 30. But, you are getting charged interest for only 15 years instead of 30 years, so you pay much less in total over the course of the loan.

 

FINRA explains:

“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.”

 

 

5) True or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.

 

The answer is False.

 

This question gets into the concept of “Diversification”.

 

Diversifying your portfolio means owning a wide variety of securities. Consider the potential for loss if 100% of your portfolio is invested into 1 company’s stock. If that company goes bankrupt, or loses market share to a competitor, just falls out of favor with Wall Street, its share price can plummet and so can your retirement savings. In the case of employees who worked for Enron, who were encouraged to invest 100% of their savings in company stock, they lost everything. Every penny of savings they had because they failed to diversify.

 

For this reason, investors choose Mutual Funds or Exchange Traded Funds (ETFs) to invest in instead, because it spreads their investments into hundreds or thousands of stocks.

 

We explain the concept of diversification in Begin To Invest’s free eBook, which you can get by signing up for our newsletter, here:

Diversification eBook page

 

 

Diversification is an important topic to understand because it means protecting your savings. No one can predict the future, and in order to reduce the risk the uncertainty of the future brings, we diversify and own a wide variety of stocks so that our retirement does not hinge on the performance of one stock or one company.

 

FINRA explains the idea of diversification:

 

“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.”

 

 

 

Some additional “Fun” facts on FINRA’s quiz:

National Average: 2.88 answers correct

State with the lowest average score: Mississippi – 2.51 average correct answers.

State with best average score: Montana – only 4.37 average correct answers.

 

 

So, how well did you do?

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