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?