The Wall Street Journal published a blog a few weeks 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 answers to the three multiple questions were provided at the end of the post, 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 answers right, you might feel not-very-smart and that’s not allowed here on The Money Coach.
No stupid questions, just an industry that is most profitable when financial literacy is at a minimum.
So 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 you 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 questions asks how much you will haver after 5 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, therefore 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, each and every year, but so does your year-on-year interest. So in the second year, your $2.00 of interest (from the first year) is also earning 2% interest. And then in year three, your $4.04 is earning 2% interest, and the $$ and the years go by.
A common (and understandable) mistake is to take the 2% per year and multiply by it by 5 (the five years in the question) which is 10%, and so $100 x 10% is $110. This however, is not correct because when your interest is paid annually (once every year), your interest payment then becomes part of your original amount (so at the end of year one, $100 because $102) and then also earns interest for each and every year thereafter.
The concept of future value/compound interest/time value of money is one of the top three of this blog. It is so important to understand, both in how earn money, but also in how you owe money (i.e. debt – mortgages, car loans, etc. work in the same way, against you – being, you have to pay interest on your interest. More on this in the coming weeks.)
Like what you just read here?
Subscribe and never miss a single post (it's free).