April is Financial Literacy Month!
Being well versed in financial literacy should be among our top priorities. To be better acquainted, see how you do in a short quiz below. The answers will follow with explanations of important financial concepts. Financial literacy is recognized formally in April but these skills are required for everyday money decisions.
To make informed family decisions, you need to tackle what it means financially. Basic financial concepts are essential to your short term and long term planning so you can accomplish your goals. For example, when buying a car, your family should consider alternatives such as a used versus new car; lease, loan or purchase; and what that means in related interest payments. Purchasing a house has its own complexities. On the other hand, we make day-to-day financial decisions when shopping for groceries, paying bills, using our credit cards, investing or saving for retirement.
How we handle our money has consequences. While some of us do a better job than others, we all have weaknesses. I am not just referring to buying a $5 latte. It’s more than that. Improve your finances in small steps through a greater understanding of financial literacy. Take the financial literacy quiz then we will review the following concepts:
Important Financial Concepts You Need To Know:
- The Magic of Compound Interest
- Inverse Relationsip Between Bond Prices And Yields
- 15 Year Vs. 30 Year Mortgages
- Debt And Interest Payments (or compound interest in reverse)
- Diversification Strategy
- Rule of 72
But First, Let’s Discuss Saving Money
They tend to spend more than they earn. You can slow your spending by understanding your costs better and create your own budget plan. Pick off easy places to save money. Eat out less often and reduce shopping impulsively.
When shopping, I have often experienced cognitive dissonance, a common post-purchase behavior. I have that feeling of unease or guilt after I purchased something. Did I really want it or did I mistakenly think I needed it?
My Husband, The Impulsive Shopper
My daughter, Alex came into our bedroom one evening, peered at two shoulder bags I had bought, still residing in their respective store bags from two different stores.
Daughter to mom: “Why are you not using them and why did you buy two at the same time?”
Mom to herself, silently: “Because your father, the impulsive buyer, came along and said, ‘why not buy both, Linda?’ and your mom listened to him for a change.”
So we all have our own quirks and need to have better saving habits.
5 Goals When You Are Saving Money:
1. Emergency Funds
The emergency fund is a great place to start. Aim for six months’ liquidity to have a buffer for your essential costs: food, rent or home payments (mortgage, utilities and such). Invest these savings in a bank account that has largely cash-equivalent securities. For more on emergency funds, please read here.
2. Save For Retirement Funds
Putting aside money for your retirement accounts is important. It is less painful when done early and automatically through your workplace or your own accounts. Read our blog on saving for retirement as early as your 20s.
3. Spend Within Your Means
Spend less than you earn by having a monthly budget to better understand your costs. According to FINRA, only 40% of Americans spend less than their household income. See our post on creating a budget. Review and tackle some of your costs with money saving ideas.
4. Avoid Debt And Pay It Off
Pay your monthly credit bills in full, not just the minimum amount. Only 32% of Americans pay their credit cards in full. The majority of those who don’t pay the balance in its entirety, face a high borrowing rate (15% on average) that will stretch out the number of years you can pay down this costly debt and increase your total borrowing costs.
5. Shorter Mortgage Terms Are Better
When taking out a mortgage loan for your home, consider the 15 year versus 30 year terms. You will make higher mortgage payments but by cutting the term in half, your total borrowing costs are significantly lower.
We need to actively manage our money to the best of our abilities. Money is a critical part of our lives and can impact our peace of mind.
The 2008-2009 recession was a tough experience and exposed many to the hardships of poor financial decision-making. Many people lost jobs, often both adults in the same family, making it difficult to pay off debt.
Take the financial literacy quiz down below.
While April is designated as Financial Literacy Month, a greater emphasis on financial literacy emerged after the Great Recession.
The first national study of financial capability of American Adults began in 2009, resulting in “The National Financial Capability Study” (NFCS). This was a project of the FINRA Investor Education Foundation.
Greater Awareness of Financial Education
Among the study’s accomplishments is the creation of greater awareness of the need for financial education for adults through a six question test including a bonus question. The questions use the most basic math skills.
These questions are used to evaluate financial knowledge, covering basic concepts of economics and finance that may be found in our everyday lives, along with calculations related to interest rates, inflation, risk, diversification and compound interest.
FINRA has published data from the NFCS study explaining results which I share at the end.
The Federal Reserve also adopted these questions for the 2016 Survey of Consumer Finances and collected respondents’s ratings of their own level of knowledge. Not surprisingly, those at higher income and with higher levels of education did better on the test.
My husband, the spender in the family is not always the best decision-maker when it comes to money management. As a result, he had some trouble with the questions below. He feels he is excused becaause he is an attorney. Many lawyers choose the profession because they are poor in math.
FINRA Financial Literacy Quiz
Can you answer the following questions? Comprehensive answers will follow.
Suppose you have $100 in a savings account, earning 2% interest per year. After 5 years, how much would you have?
Choice A More than $102
Choice B Exactly $102
Choice C Less than $102
Choice D Don’t know
Imagine that the interest rate on your savings account is 1% per year and inflation is 2%. After one year, would the money in the account buy more than it does today, exactly the same, or less than today?
Choice A More
Choice B The same
Choice C Less
Choice D Don’t know
If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
Choice A Rise
Choice B Fall
Choice C Stay the same
Choice D No relationship
Choice E Don’t know
Questions 4 and 5 are True or False Questions
A 15-year mortgage requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.
Buying a single company’s stock usually provides a safer return than a stock mutual fund.
Question 6 is a Bonus Question.
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?
Choice A Less than 2 years
Choice B 2 to 4 years
Choice C 5 to 9 years
Choice D 10 or more years
Choice E Don’t know
Each of the above questions deal with important financial concepts.
The Magic of Compound Interest
The first question deals with the all important compound interest principle, the key to growing your wealth. By putting $100 in a savings account earning 2% interest per year, you are earning interest on interest along with interest on your the principal amount. In this question, you will earn more than $102.
To better illustrate the power of compound interest is the classic question, “what would you rather have, a penny that doubles everyday for 31 days or $1,000,000?” And the answer is ….the doubling penny which yields $9,737,418.24 more than the one million dollars!
Now, it is not reasonable to assume a 100% annual growth rate for any investment annually, let alone on a daily basis.
However, if you save $2,000 per year in an investment account early in your lives at a more reasonable 8% return, and save an additional $500 per month on top of that, over a 35 year period, you could accumulate $1.1 million. Try using a compound interest calculator.
The power of compounding interest, linked to the time value of money, will benefit you the most if you invest early and let your earnings accumulate and grow rather than withdraw money from your accounts.
The second question is asking about the effects of a 2% inflation rate that is outpacing the 1% interest rate on our savings account. This means you would have less in one year than today (Choice “C”), by 1 % in buying power. You would need have a 2% savings rate to stay even.
Inflation refers to a general rise in prices on goods and services that we buy. A 2% inflation rate reflects a stable economy and is usually measured by the Consumer Price Index (CPI) and other price indices.
CPI measures the weighted average of a basket of consumer goods and services, such as food, transportation, clothing, medical care and energy. Medical costs, in particular rise faster than the average inflation and plays havoc with those depending on those products and services.
Unless we get at least a 2% raise in salary or can earn a return that keeps pace with inflation, we would fall behind in our purchasing power.
If Mary earns a salary of $60,000 and gets a $1,000 annual raise, or 1.7% increase, she will be slightly behind if inflation is 2%. However, if inflation grows to 6%, and she gets an additional $1,000 a year later, her $62,000 salary is still behind as her cost of living will outpace her compensation.
Inflation and other economic indicators affect our daily lives. Read this post on why we need to understand the Fed and how they impact interest rates and money in our financial lives.
How Do We Feel the Effects of Inflation?
We experience higher prices in food at the grocery store. Food costs have been rising faster than the inflation rate for years for a variety of reasons. Higher oil prices increase shipping costs, weather conditions like droughts cause shortages in some products, and simply our desire for healthy and “organic” food drive up demand and prices for certain foods.
Remember the egg shortages because of bird flu epidemics? This led to higher prices for eggs as well as more people turning to vegan diets.
Have you noticed the shrinking jars of spaghetti sauce at your grocery store? Thirty two ounce jars became 26 ounce jars, then more recently, 24 ounce jars, with the smallest jar selling at the same price as the 32 ounce jar at the blink of eye? That is inflation, my friends.
When Interest Rates Rise, Bond Prices Fall
The third question asks about what happens to bond prices if interest rates rise. Bond prices will fall. This is an important question for bond investors. Bond prices have an inverse relationship to interest rates, meaning that if interest rates rise, bond prices will decline.
If you are a bond investor, or own bonds as part of your diversified investing strategy, you need to understand the role of interest rates on your investment portfolio.
Treasuries, Muni’s and Corporate Bonds
As interest rates rise, newer bonds that are being issued by the US Treasury, state and local governments (ie municipalities) and corporations will come to the market with higher interest rates.
The prices of older bonds you may be holding in your portfolio will likely to go down as a result. This happens unless you own inflation-indexed bonds where the principal is indexed to inflation and protect the holder (a separate topic for another day).
All bonds have interest rate risk, even US government bonds which typically do not do have default risk because of its superior AAA rating as compared to the varied ratings for munis and corporate bonds.
15 year versus 30 year mortgage loans
The fourth question assumes interest rates are the same for 15 year and 30 year mortgage loans. In reality, they are usually different rates. In a true/false question, it poses whether a 15 year mortgage requires higher monthly payments but results in lower total interest over the life of the loan compared to the 30 year loan. Yes, this is correct and is often the reason many consumers prefer the shorter time frame.
This is true for all loans, including car loans, business loans and even credit cards.
When you spread out your time table for paying back your loan, you may be paying a lower amount but you are paying more interest for the longer period. If you can work it into your budget, opt for the shorter time frame, to get rid of your debt load faster.
It is compound interest working in reverse to your detriment.
About half of consumers pay only the minimum amount due by their credit card company. Paying the minimum amount may be attractive since you avoid late fees. It also won’t impact your credit score. However, you are increasing your borrowing costs and making it more difficult for you to be debt-free.
The fifth question addresses a very important topic: diversification with the True/False statement: Buying a single company’s stock usually provides a safer return than a stock mutual fund. FALSE!
A diversification strategy is the best way to spread risk in your portfolio. A stock market fund is usually managed by a portfolio managers with experience and expertise. While mutual funds charge fees, there are a number low fee index funds that are attractive and diversified for the average investor.
A True Story
I once knew someone who was fairly successful and ran his own portfolio, which was dominated (more than 90%) by one stock for a long time.
He owned a few other investments but was comfortable maintaining a non-diversified strategy and he did not have to pay fees to anyone else.
That one stock was Countrywide Financial, a company that at its peak in the early 1990s was the largest mortgage originator of single-family homes in the US. Countrywide Financial was heavily exposed to subprime mortgages (better known as toxic mortgages later on).
Countrywide Financial was called the “23000% stock” by one major magazine for the tremendous returns it generated from 1982-2003. Countrywide and other lenders were providing loans without full credit background checks and without requiring down payments.
The Collapse of Countrywide Financial
In the summer of 2007, Countrywide revealed its enormous liquidity problems as mortgage delinquency rates soared, especially those subprime mortgages held by families with poor credit histories.
The company literally avoided total collapse by jumping into the arms of Bank of America in January 2008 at a bargain basement share price.
Imagine if the one stock you owned in your multimillion dollar portfolio was Countrywide in 2008? Clearly, you would have wished you had been diversified!
Rule of 72
Bonus question 6 asks you to suppose that 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?
For a moment, ignore the compounding of interest.
The Rule of 72 is a simplistic formula used to determine how long an investment will take to double given a fixed rate of return.
The formula for this rule is 72 divided by interest rate or 72/20 and equals 3.6 years.
Under the compounding interest method, the amount takes a bit longer, or close to 4 years. As mentioned earlier, it is always key to use the magic of compounding in your favor and for money growth, not debt. For other financial ratios like the Rule of 72, read this related post.
So how did you do on the quiz? Probably Better Than My Husband!
There are a number of financial literacy quizzes to test your personal finance know-how but in this short version, it does highlight a number of key areas to know.
FINRA provided results from its study with the national average at 3.16 correct answers out of 6 questions. It also provided a scores by state, with Montana having the highest score of 3.78 versus Texas registering the lowest score of 2.81.
Clearly, we all need to do a better job at financial education. That provides us with the greatest opportunity to grow our wealth.
Oh yeah, I forgot to mention that my husband, the spender, only answered three (!) questions correctly.
Remember my spendthrift husband, Craig? His financial habits were poor, resulting in a low score. Craig is a smart guy except when it comes to money. His mismanagement of money can be frustrating. Read more about that here in this post about 9 Ways To Avoid Financial Infidelity here.
Financial Literacy may be recognized in April but learning personal finance skills should be a year-round goal. Taking the quiz to test your financial literacy know-how is only the tip of the iceberg. You can learn how to handle money better at any time. Challenge yourself to improve your financial health.
How did you do on the test? What are some the financial literacy tools you use to better your financial situation. We would appreciate any thoughts, feedback or comments you are willing to share.
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.