Financial Literacy Quiz
The below financial literacy quiz is directly from FINRA, the “Financial industry Regulatory Authority.” They are the regulatory body that writes and enforces the rules that govern how financial institutions and financiers operate. Their quiz includes the “Big Five” questions that are the golden standard for assessing a person’s financial literacy.
Question 1:
Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, how much would you have?
-
Correct! Earning 2% interest a year means you will receive an additional 2% on the money you have in your account (usually including the interest you already earned). In this case with $100 in a savings account, your account would look as follows.
Today: $100
In 1 year: $102 ($100 x 1.02)
In 2 years: $104.04 ($102 x 1.02)
In 3 Years: $106.12 ($104.04 x 1.02)
In 4 Years: $108.24 ($106.12 x 1.02)
In 5 Years: $110.41 ($108.24 x 1.02) -
Not quite! Remember, you are earning 2% interest per year, for 5 years, not just one.
-
Not quite! If you thought it was less than $102, you likely got confused by the word “interest” and who is paying who. In this situation, the bank is paying you (as “compensation” for having your money with them vs. somewhere else). In other situations, you may be paying “interest” if you owe money to someone else (such as on a credit card).
Question 2:
Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?
-
Not quite! This question can be a bit tricky as it is asking about our buying power, not the amount of money in our account. In this instance, our future buying power can be determined by comparing the interest rate we are earning to the rate of inflation. Since we are earning 1% interest, but inflation is 2%, our buying power is shrinking.
If you are curious about the amount of money in the account, it grew 1% (say from $100 to $101 after 1 year) however that $101 is actually worth less than the $100 originally due to inflation. This gets into a well-known finance concept called “the time value of money.” -
Not quite! This question is asking about our buying power, not the amount of money in our account. Both the amount of interest we earn and inflation will impact how much we can buy. Don’t get discouraged, and try again!
-
Correct! This question is asking about our buying power, not the amount of money in our account. In this instance, our future buying power can be determined by comparing the interest rate we are earning to the rate of inflation. Since we are earning 1% interest, but inflation is 2%, our buying power is shrinking.
Question 3:
If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?
-
Not quite! 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.
-
Correct! 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.
For illustrative purposes, you can think of bonds as a rental lease (as they are contracts of scheduled payments) and interest rates as rental rates (going market rates). If the market rental rate of a house goes up, but the landlord is locked into a lease with a tenant, then his or her lease agreement becomes relatively less attractive because they could have locked in the higher rate rental rates. Similarly, the reverse is true. -
Not quite! Interest rates determine the cost of borrowing and bonds are a form of borrowing. As interest rates go up, newer bonds come to market paying higher interest yields than the bonds that already exist. Does that make those existing bonds more or less attractive from the lender’s perspective?
-
Not quite! Interest rates determine the cost of borrowing money, and bonds are a form of borrowing.
Question 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.
-
Correct! All else equal, 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.
-
Not quite! This is the trade off when adjusting the term for mortgages (all else equal). Either you pay lower amounts over the life of the loan and pay more in interest over time, or you pay higher amounts but less in interest over time.
Question 5:
True or false: Buying a single company's stock usually provides a safer return than a stock mutual fund.
-
Not quite! A stock mutual fund can be thought of as a collection of companies stocks (and other investments). Additionally, “risk” in finance refers to the chance that an outcome will differ from the expected return, or in some cases the possibility of losing some or all of an investment. Buying a single company’s stock is more risky as it more likely for that single company to go out of business (compared to all companies in the mutual fund). Further, a single company has more risk as “swings” in outlook or performance (positive or negative) will more greatly impact the investment compared to all swings across a group of stocks.
-
Correct! 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.
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 interest rate, how many years would it take for the amount you owe to double?
-
Not quite! Try again.
-
Correct! While some may be tempted to say 5 years, the correct answer is 3.5 years due to compound interest. In finance, there is the “rule of 72” which is a method for estimating an investment's doubling time. You can determine the number of years it takes for an investment to grow by dividing 72 by the annual interest rate . In this case, 72/20 = 3.6 years. In finance, the rule of 72 is a method for estimating an investment's doubling time.
Further, here is how the amount owed grows for this question (remember it’s compound interest):
Year 0: $1,000
Year 1: $1,200 ($1,000 x1.2)
Year 2: $1,440 ($1,200 x 1.2)
Year 3: $1,728 ($1,440 x 1.2)
Year 4: $2,073 ($1,728 x 1.2) -
Not quite! You may have been tempted to select this answer as 20% of $1,000 is $200 and 5 x $200 is $1,000. While sound, this logic assumes simple interest (meaning interest only on the initial amount of the loan). The majority of situation in finance assume compounding interest (or interest on top of interest). Here is the difference:
Simple Interest:
Year 0: $1,000
Year 1: $1,200 ($1,000 + ($1,000 x 0.2))
Year 2: $1,400 ($1,200 + ($1,000 x 0.2))
Year 3: $1,600 ($1,400 + ($1,000 x 0.2))
Year 4: $1,800 ($1,600 + ($1,000 x 0.2))
Year 5***: $2,000 ($1,800 + ($1,000 x 0.2))
Compound interest:
Year 0: $1,000
Year 1: $1,200 ($1,000 x 1.2)
Year 2: $1,440 ($1,200 x 1.2)
Year 3: $1,728 ($1,440 x 1.2)
Year 4***: $2,073 ($1,728 x 1.2)
Year 5: $2,488 ($2,073 x 1.2) -
Not quite! Try again.
Question 7:
Which of the following indicates the highest probability of getting a particular disease?
-
Correct!
Option 1 = 5% chance
Option 2 = 2% chance
Option 3 = 2.5% chance -
Not quite!
Option 1 = 5% chance
Option 2 = 2% chance
Option 3 = 2.5% chance -
Not quite!
Option 1 = 5% chance
Option 2 = 2% chance
Option 3 = 2.5% chance
How did you do?
According to FINRA’s results page for this quiz, the national average score is 3.2 questions correct.