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:

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?

More than $102

Exactly $102

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.

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.

Potenti sapien sit mattis sed scelerisque dictum. Pellentesque malesuada tellus curabitur ullamcorper proin. Adipiscing quis in nec ullamcorper sit a tortor eu venenatis. Hac imperdiet est sed quam tempor quam malesuada sed mattis.

Nulla neque volutpat viverra nascetur integer. Parturient semper habitant mi dignissim dui. Adipiscing metus sed tellus amet mauris ut mattis nec dui. At pharetra suscipit etiam lorem odio sed arcu odio lobortis. Praesent id faucibus elementum elementum tempor. Nunc leo proin ut dui ullamcorper amet fermentum placerat eget.

“Ut lectus non sed convallis facilisis facilisis in pharetra. Hac imperdiet diam pretium dictum adipiscing id facilisi dignissim elementum. Felis risus facilisis odio in at facilisis suscipit.”