• Skip to main content
  • Skip to footer

the Money Coach

  • ABOUT
  • BLOG
  • ASK
  • BOOTCAMP
  • CONTACT

April 23, 2021 By Nanci K. Murdock, CFA

Financial Literacy: Three Answers

how to calculate compound interest

The Wall Street Journal (WSJ) published an article a few years back,  a three-question test of financial literacy (which, of course, unleashed fury in the comments on financial literacy – or lack thereof – in North America.) But what I did notice was that while the WSJ provided the answers, no one took the time to explain why the answers are the answers. 

Which I think is not so great because if you didn’t get all or any of the answers right, you might feel not-very-smart and that’s not allowed here on The Money Coach.

There are no stupid questions, just an industry that is most profitable when financial literacy is not part of the equation.

Let’s do this! The first question was: 

1. Suppose you had $100 in a savings account, and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow?

A. More than $102

B. Exactly $102

C. Less than $102

The answer to this lies in understanding the concept of compound interest. You can click that for the Wikipedia definition, but here is mine:

If you have $100 and put it in a savings account that pays 2% per year, at the end of the first year, you will have $102. (100 x 2% or 100 x 1.02 = 102). So that is after one year. The question asks how much you will have after five years. 

Working this out from day one: 

Year one: 102 x 1.02 = $102

Year two: 102 x 1.02 = $104.04

Year three: 104.04 x 1.02 = 106.12

Year four: 106.12 x 1.02 = 108.24

Year five: 108.24 x 1.02 = 110.40

After five years, you would have $110.40, which is more than $102. 

The answer is A.

If you break this down, the magic of compound interest is that not only does your original amount (in this case, $100) earn interest every year, but so does your year-on-year interest. In the second year, your $2.00 of interest (from the first year) also earns 2% interest. And then, in year three, your $4.04 is earning 2% interest, and you get the idea. 

A common (and understandable) mistake is to take the 2% per year and multiply by 5 (the five years in the question), which is 10%, and so $100 x 10% is $110. However, this is not correct. When your interest pays annually (once every year), your interest payment becomes part of your original amount (so at the end of year one, $100 because $102). And so, for each subsequent year, your new capital amount is higher than the year before.  

Got it?

Answers to questions two and three are here and here. 

Like what you just read here?

Subscribe and never miss a single post (it's free).

Success! Now check your email to confirm your subscription.

There was an error submitting your subscription. Please try again.

Powered by ConvertKit

Filed Under: investing

About Me.

I'm Nanci Murdock. I am a Montreal based money coach who helps women who want to learn how to invest on their own but might not know where to start.

Read more about Nanci »

First time here?

Check out https://themoneycoach.com/start and find out what the most significant risk facing women investors in 2021 (hint: it has to do with longevity risk, or outliving your money), and how to avoid it. 

Previous Post: « Thousands of Canadian Investors, Just Like You, Are Being Robbed of Investment Returns

Footer

Join the Facebook Group

Money Wealth. Abundance. Love it. The Facebook Group.  Click here to join today (it's free). 

ASK ME A QUESTION

nanci @ themoneycoach dot com

/Ask Nanci

About me

I help women who want to learn more about investing but might not know where to start.

/read more.

AS SEEN IN

 
 

[gdpr_privacy_safe]

Copyright © 2020 · Nanci K. Murdock, CFA · Terms of Use · Privacy Policy · Privacy Tools · Disclaimer

  • ABOUT
  • BLOG
  • ASK
  • BOOTCAMP
  • CONTACT