In 2012, the Financial Industry Regulatory Authority Investor Education Foundation performed a nationwide study on financial competency in the U.S., expanding on a previous 2009 study.
As part of the study, FINRA developed the five-question quiz to the left of this column. Take the quiz now, then continue reading to find out how well you did compared to the rest of the country and to find out the explanation for the correct answers.
If you answered all five questions correctly, then congratulations! You’re a part of the 14 percent of Americans who are money management pros.
But don’t worry if your score wasn’t perfect. The national average is 2.88 correct answers, and in Louisiana, it’s only 2.67.
This simple quiz tests several areas and concepts of personal money management, but most Americans won’t pass the quiz.
Question one tests your knowledge of compounding interest.
After year one, your savings account will have a balance of $102 because you earned $2 interest. Compounding interest means you will now earn interest on the $102 in your savings account, and during year two, you will earn $2.04.
If you continue this for all five years, your balance will be $110.41.
Question two continues with the concept of interest, throwing in inflation — the rate by which prices for goods and services increase. You can also think of it as the value of the dollar decreasing. We call this your purchasing power.
In the question, inflation is greater than the interest you’re earning by one percent. Inflation has outpaced interest, so your purchasing power has gone down.
Let’s visualize this in a scenario where your savings account has $100 in year one.
With one percent interest, you’ll have a balance of $101 in year two. But two percent inflation means your $101 has the buying power of $98.98 in terms of year one’s dollar amount.
Question three sees if you understand the basics of how bonds are priced.
Bonds are agreements where you loan money to either the government or a corporation and are generally very safe investments.
Interest is the amount of money you will be paid when you purchase a bond. When interest rates go up, you’re being paid more to buy a bond.
This makes older bonds worth less because their interest rates are lower, so you get paid less. Bond price and interest rates always have an inverse relationship.
Question four tests you on mortgages. The two most common mortgages are 15-year and 30-year loans. In mortgages, most of the money you pay goes toward interest on your loan rather than the price of your house.
In a mortgage of $150,000 and six percent interest, a 30-year mortgage monthly payment costs less. However, over the life of the mortgage, the 30-year loan will cost around $100,000 more than a 15-year mortgage.
The final question tests your knowledge of investing in stocks.
Mutual funds are managed investment funds that operate by the theory, the more money available to invest, the more opportunity there is to make money. If you buy shares of a mutual fund, you’re buying a share of a large investment fund.
In a mutual fund, you’ll be buying shares of multiple stocks and diversifying your investments.
Diversification means you are invested in different areas of the economy. This is favorable because if one section of the economy goes down your losses are offset by other sections that are not declining.
If you buy just a single stock, all of your eggs are in one basket. If the stock goes down, all of your investments lose money. This makes buying mutual funds a safer option.
Now you’re able to ace this quiz and show everyone you know more about finances than 86 percent of the population.
If you missed any questions on the quiz, I encourage you to read up on the areas you got incorrect.
These questions were designed to test you in areas of personal finance that are relevant in everyday life, so you won’t be wasting your time.
Jay Cranford is a 20-year-old finance junior from St. Simons Island, Georgia. You can reach him on Twitter @hjcranford.