The Four Points of Financial Literacy
As you’ve probably heard, April is financial literacy month, and as April comes to an end, it’s time to reflect on your own degree of financial literacy. In order to assess financial literacy, consider these four criteria from Standard & Poor’s Global Financial Literacy Survey. According to S&P, financial literacy requires an understanding of interest rates, interest compounding, inflation, and risk diversification. Test your understanding with the questions below, borrowed from S&P’s survey. If you’re unsure about the question or answer incorrectly, make sure to read the explanation.
Q: Suppose you need to borrow $100. Which is the lower amount to pay back: $105 or $100 plus 3%?
A: $100 plus 3%
Explanation: Interest is the cost of borrowing money. This question is an example of simple interest: interest that’s calculated on the original amount of a loan. Since the interest for this $100 loan is 3%, the interest amount in dollars can be found by calculating 3% of $100, which is $3. $100 plus $3 is $103, which is, of course, less than $105.
Q: Suppose you put money in the bank for two years and the bank agrees to add 15% per year to your account. Will the bank add more money to your account the second year than it did the first year, or will it add the same amount both years?
A: The bank will add more money to your account the second year.
Explanation: Unlike simple interest, which is only calculated on the original amount of a loan, compound interest is calculated on the original amount of a loan and the interest accrued from previous periods. Thus, compound interest rates increase over time. Think of compound interest as interest on interest. Compounding interest can be good when it comes to savings accounts, but you don’t want compounding interest on your debt.
Q: Suppose over the next 10 years the prices of the things you buy double. If your income also doubles, will you be able to buy less than you buy today, the same as you buy today, or more than you buy today?
A: You will be able to buy the same as you buy today.
Explanation: Inflation is an increase in the price of goods and services over time. As the price of goods and services increases, the spending power of currency decreases. However, often as the price of goods and services increases, wages and salaries increase too. For example, in 1950, gas cost $0.27 per gallon, compared to $2.88 today, according to Business Insider. However, the average household income also increased; in 1950, the average household income was $3,300, whereas today, it’s $61,372, according to the US Census. Thus, even if the price of things you buy doubles, if your income also doubles, your shopping list probably won’t change.
Q: Suppose you have some money. Is it safer to put your money into one business or investment, or to put your money into multiple businesses or investments?
A: It is safer to put your money into multiple businesses and investments.
Explanation: Have you heard of the saying, “Don’t put all your eggs in one basket”? Risk diversification applies this adage to the financial world. Diversification reduces risk by investing in an array of businesses, industries, and instruments. With this strategy, if one of your investments falls due to something like a workers’ strike, this drop can be counterbalanced by an investment in an industry that is doing well.
Hopefully, these questions gave you an estimate of your familiarity with interest rates, interest compounding, inflation, and risk diversification. However, this is just a simplified overview. To expand your financial literacy, it’s important to stay updated on financial news and to regularly meet with financial professionals whose expertise goes far beyond the surface of these topics. Financial literacy is an ongoing, collaborative effort: there’s always something new to learn, and your financial knowledge can only grow so much on your own.
- Fontenot, Kayla, et al. “Income and Poverty in the United States: 2017.” United States Census Bureau, United States Census Bureau, 12 Sept. 2018, www.census.gov/library/publications/2018/demo/p60-263.html.
- “Income of Families and Persons in the United States: 1950.” United States Census Bureau, United States Census Bureau, 4 Sept. 2018, www.census.gov/library/publications/1952/demo/p60-009.html.
- Klapper, Leora, et al. Financial Literacy Around the World: Insights from the Standard & Poor’s Ratings Services Global Financial Literacy Survey. World Bank Development Research Group, 2014, Financial Literacy Around the World: Insights from the Standard & Poor’s Ratings Services Global Financial Literacy Survey.
- Konen, Leah. “How Well Can You Live On Minimum Wage?” Business Insider, Insider Inc., 5 Apr. 2012, www.businessinsider.com/minimum-wage-and-what-it-buys-you-1950s-to-now-2012-4.