There's a lot to know about your money. Unfortunately, many Americans don't know some of the basics that are important to making sound financial decisions. In fact, the Federal Reserve reported recently on how well Americans did when answering four basic financial literacy questions -- and there were a surprising number of incorrect answers.
Can you correctly answer the questions that 30% or more of your fellow Americans could not? Read on to find out.
1. Can housing prices in the U.S. ever go down?
When asked whether it was true that housing prices in America could ever fall, just 60% got the answer correct; 19% percent got it wrong, and the rest said they didn't know or failed to answer.
The correct answer, of course, is that housing prices can fall -- sometimes dramatically. In fact, from 2005 to 2008, the average price of existing single-family homes in the United States dropped by around 26%.
While it is true that over time, real estate prices tend to rise, the increase has only slightly beaten the level of economic inflation. Plus, while your home value may increase slowly over many decades, that doesn't help you much if you bought at the height of a housing bubble and have to sell two years later.
Knowing housing prices can do down is essential to understand the importance of a home down payment. If you buy a house with no down payment and prices fall, you'll be trapped in your home unless you come up with cash to pay off any balance remaining on your mortgage above what your home sells for. Otherwise, you would have to get the bank to agree to a short sale, and would ruin your credit rating -- and you don't want that.
2. Is it safer to buy a company stock or a mutual fund?
When asked whether buying a company stock provides a safer return than a stock mutual fund, just 46% of survey-takers answered correctly, compared with 4% who were incorrect and 50% who said they just didn't know or chose not to answer.
The answer: buying mutual funds provides a safer return. With a mutual fund, your money is pooled with cash from other investors, and all that money is invested in many different assets. For example, a mutual fund might buy stocks of many large or small U.S. or foreign companies.
By spreading your cash around among different companies, you ensure you don't lose everything if one of the companies goes bust. Since it's impossible to predict with 100% certainty that the company you're investing in will never fail, spreading around your cash is a safer move.
3. How will inflation affect your buying power?
Survey participants were told the interest rate on a savings account was 1% annually and inflation was 2% annually. They then had to answer: Would you be able to buy more than today, the same as today, or less than today, after keeping your money in the account for one year?
Sixty-two percent got this one correct, compared with 12% who got it wrong, and roughly a quarter who didn't know or didn't answer. You would be able to buy less than today because prices went up 2% thanks to inflation while you earned only 1% on your invested funds.
Understanding the impact of inflation is important. Inflation is a general increase in prices that causes a decline in purchasing power. Because of inflation, $1 sitting in your wallet today won't buy you as much tomorrow.
You need to know this because it can guide your investment decisions. If you leave your money under your mattress or invest it in anything that doesn't earn at least as much as the inflation rate, your purchasing power will continually erode. You may think you're keeping your money safe, but you're actually getting a little bit poorer every day.
4. How will interest affect you?
Finally, survey respondents were asked a question aimed at determining if they understand how interest works. They were told they had $100 in a savings account paying 2% annually and asked how much they'd have in the account after 5 years.
Seventy-one percent correctly said they'd have more than $102, but 12% incorrectly guessed they'd have $102 or less, and the rest didn't know or didn't answer.
When an account pays interest, the interest payments are added onto your principal balance -- thus your account balance grows. The frequency at which interest payments are added onto your balance depends how often interest compounds.
- If interest compounds daily, 1/365th of your annual interest is added onto your principal balance each day.
- If interest compounds monthly, 1/12 of your annual interest is added onto your principal balance every month.
- If interest compounds annually, annual interest is added onto your principal balance each year.
Once interest compounds, you're paid interest on the interest. That would mean each day, month, or year, you'd earn interest on a slightly higher principal amount. After 5 years, your $100 initial investment would always have grown to more than $102 if you're paid 2% interest because you'd earn 2% interest every one of those five years. The exact amount, though, would depend on how often interest compounds.
Understanding how this works is important not only so you can better understand how much you stand to earn from an investment, but also so you can see how damaging it can be to get into debt and owe interest. If you carry a credit card balance and interest compounds daily, the amount you owe goes up a little bit every day.
Understanding the basics is key to financial success
Understanding basic concepts about investing, interest, and inflation is essential so you can make informed choices about your funds. Hopefully, now you know the answers to these questions if you didn't before. You can learn more about personal finance and money management by checking out some of our guides, including our guide to investing for beginners.