Sunday, December 20, 2015

Should we be required to take a financial literacy test? When it comes to interest rates, yes

"Compound interest is the eighth wonder of the world. He who understands it, earns it...he who doesn't... pays it," -- Albert Einstein, physicist. (1879-1955).

Interest rates have constantly been in the news as the Federal Reserve Board of Governors dithered and then finally raised a key interest rate charged to U.S. banks. But how well does the average American understand interest rates and the role they play in our financial lives? For that matter, how is the rest of the world doing with interest rate financial literacy?

A new worldwide study from Standard & Poor’s Global Finance shows that many people have difficulty understanding the basics of interest math -- How compound interest works (when you earn interest on re-invested interest), the effects of inflation on savings and what loan interest rates mean.

Those who don’t get these concepts are more likely to be ripped off by payday lenders, fork over higher credit card fees and misunderstand what they are in for when they take out a loan to buy a house or a car. (The Great Recession was in part the result of lending to people money who should never have been allowed to take out mortgage).

Oh, and there's that itty bitty interest annual rate fee charged by our 401(k) retirement savings that over time adds up to thousands of dollars in lost income.

The S&P research reveals that a third of the American population does not grasp the basic concepts of interest and how interest is calculated. These folks could not correctly answer this simple question: Which is greater: $105 or $100 plus 3 percent?

This lack of financial literacy is a global problem, even worse in some other countries than in the U.S. For example 60 percent of the world’s population could not correctly answer the above question.

But when we buy a house, when we take out a loan and pay interest to the lender for the cost of the loan, it seems essential that we understand how interest rates function. But three in 10 Americans with a housing loan are unable to perform basic interest calculations on their loan payments, said the study.

Same when buying a car. We pay back the loan plus an interest fee on the loan until it’s all paid off. Interest rates come up in other ways. The rising cost of living is figured as an inflation rate…calculated as a percentage increase each year.
Do people understand that by putting cash under a mattress, they are actually losing money because inflation eats into the buying power of the cash? (For more info, click here.)

Our children are charged an interest rate on their student loans. And when we put money into a saving account or certified deposit, we earn interest on that savings (or soon will, if interest rates keep going up). It's important to know that you can pay interest, and as well, earn interest. But even in advanced economies like ours, one-third of the population does not understand interest rates, the Standard & Poor research indicated.

What can be done to help people become more financially literate about interest rates?
It seems clear that we should be doing a better job in schools (maybe junior high, or younger) to educate our kids on basic math related to real life….credit card interest rates, how mortgage loans and car loans work, how compound interest works with a savings account.

In addition, should we be required to take a financial literacy test when we open a bank account or take out a mortgage loan? We see health warnings on the back of cigarette packs. Why not require regulators to educate borrowers on the risks and rewards of interest rates when they sell a loan product, asked the folks at S&P Global.

In teaching our grandchildren about money, get them to think about compound interest earnings by asking this question: "Would you rather have $1 million, or start with one penny and double your savings each day for four weeks?" Because a million dollars is a lot, and pennies are not, most kids will confidently choose the million dollars. A chart at will show them why at the end of four weeks compound interest will have earned back the $1 million, plus an additional $342,177.28. Click here.

By the way, that question ---  which is greater: $105 or $100 plus 3 percent? Sixty percent of the world’s population can’t answer that correctly!

Standard & Poor's Ratings Services Global Financial Literacy Survey, click here.
Compound interest and your return,, click here.
"I want to teach my 11 year old about compound interest, click here.
"Plan, save, Succeed!, from, click here.

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