Are you financially literate? How much do you understand about interest, inflation, and diversification?
Take the quiz below to determine your level of knowledge and uncover gaps to help you make smarter financial decision. (Correct answers are explained after each question.)
- If you had $100 in a savings account, and the interest rate was 3%, what would your balance be after five years?
- More than $103.00.
- Exactly $103.00.
- Less than $103.00.
The correct answer is ‘A’, More than $103. That’s because your interest will compound. In other words, in the first year, you would earn $3.00 from your interest (which is 3% of the $100 you originally put into the account). But the next year, the 3% interest would be calculated off the new $103 balance totaling $3.03. And so on. After five years, your balance would be: $115.90.
- Let’s assume inflation is 2% per year, and the interest rate on your savings account is 1% per year. After one year, you would be able to buy:
- Less than today.
- More than today.
- Exactly the same.
The correct answer is ‘A’, Less than today. Inflation is the rate at which prices for goods rise. As inflation goes up, the spending power of your dollar goes down. If inflation is at 2% but your savings account is earning 1%, the cost of items is going up faster than your savings is. As a result, you will be able to buy less in a year with that same $100 than the previous year because the price of items increased by 2% while your savings only went up by 1% in the same time period.
- True or False: Buying a single company’s stock usually gives a safer return than a stock mutual fund.
The correct answer is ‘B’, False. It is generally safer to invest in a stock mutual fund, which includes hundreds or thousands of stocks. That’s because instead of putting all your eggs in one basket, you are investing in several via a mutual fund. This protects you from the very real possibility of any single stock affecting your overall return. This is known as diversification.
- As interest rates rise, what usually happens to bond prices?
- They rise.
- They fall.
- They stay the same.
- No relationship.
The correct answer is ‘B’, They fall. As interest rates rise, bond prices fall. And vice versa. Why? Because when interest rates rise, new bonds become available that offer higher yields or returns. Suddenly, older bonds are worth less in comparison. This explains the concern that many have of a bubble bond bursting.
- True or False: A 15-year mortgage usually means 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 ‘A’, True, based on the assumption that the interest rate is the same on both loans. Even though the monthly payments are higher with a 15-year loan than with a 30-year loan, you repay the principal much quicker with the first. That also explains why the payments are higher on a 15-year loan (more is going to principal and less to interest).
Example: a 30-year mortgage of $150,000 with a 6% interest rate will cost $899 per month (for principal and interest fees). By the end of 30 years, you will have paid $173, 757 in interest alone.
A 15-year mortgage of the same $150,000 with the identical 6% interest rate, will cost $1,266 each month (for principal and interest fees). But by the end of 15 years, you will have paid $77,841 in interest. That’s almost $100,000 less!
If you answered incorrectly to any of these questions, you are not alone. A July 2016 nationwide report showed that only 37% of Americans surveyed could answer four or more questions correctly on a five-question financial literacy test.
At Silverman Financial, we help you understand how interest rates, inflation and investments work. We unravel complicated financial terminology related to your personal finances so you can make wise financial decision for your future.