Maybe you want to achieve a certain degree of financial freedom. Maybe you want to be incredibly wealthy. Or maybe you just want to feel a little less stressed about your finances and your financial future. 

Or maybe you want to have $1 million in your 401(k) when you retire. (If so, here's how.)

Regardless of your goal, to achieve it you'll need a basic knowledge of saving and investing -- which, unfortunately, is a problem for the majority of people. According to a recent study, most people can't pass a basic 5-question financial literacy test. 

Want to see how you do?

First, the questions. The answers are below.

Financial Literacy Test Questions

1. Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, how much would you have?

  • More than $102
  • Less than $102
  • Exactly $102

2. Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?

  • More
  • Same
  • Less

3. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?

  • Rise
  • Fall
  • Stay the same
  • There is no relationship between interest rates and bond prices

4. A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.

  • True
  • False

​5. Buying a single company's stock usually provides a safer return than a stock mutual fund.

  • True
  • False

And here's a bonus question:

6. Suppose you owe $1,000 on a loan and the interest rate you are charged is 20 percent a year, compounded annually. If you didn't pay anything off, at this interest rate, how many years would it take for the amount you owe to double?

  • Less than 2 years
  •  2 to 4 years
  • 5 to 9 years
  • More than 10 years

Financial Literacy Test Answers

1. Suppose you have $100 in a savings account earning 2 percent interest a year. After five years, how much would you have?

Answer: More than $102.

If you invest $100 at 2 percent, after one year you'll earn $2 in interest.

After five years you'll have at least $10 since you earn $2 per year.

But wait, there's more: After one year you have $102, so the 2 percent interest will be applied to $102, not $100, so for year two you'll earn $2.04.

That's the power of compounding: As your savings grows, so does your return.

Which means that after five years, you'll have $110.41. That's great... but will not make you rich. Even if you somehow manage to earn a 10 percent annualized return, your savings will have only grown to $161.05. Excellent return, but in raw dollars, certainly not money you can retire on.

Which is why this next sentence is so critical: 

How much you save matters a lot more than your rate of return.

The rate of return you achieve is at least partly outside your control. But what you can totally control is how much you save.

Say you make $40,000 a year and save 3 percent of your salary. That means you save $1,200 the first year. If you earn a 4 percent return on that money, after one year you have $1,248. If you manage an 8 percent return, you have $1,296. That's not only a better return, it's two times better.

But if you increase your rate of savings by 1 percent, to 4 percent, you have $1,600 -- even if you don't generate any return at all.

And that's why, if you want to build wealth, the most important thing you can do is to focus nearly all your attention on your rate of savings, not your rate of return.

The more you save, especially early on, the more you'll have later. 

So spend a little of your time learning about investing.

And then spend most of your time finding ways to save more money.

2. Imagine that the interest rate on your savings account is 1 percent a year and inflation is 2 percent a year. After one year, would the money in the account buy more than it does today, exactly the same or less than today?

Answer: Less.

Inflation is a rate describing the rise in price of goods and services. If inflation goes up by 2 percent, that means the average cost of goods rises by 2 percent.

Which means that if you only earn 1 percent on your savings, you've taken one step forward and two steps back, for a next loss in spending power of 1 percent. 

The same is true if you get a 2 percent pay increase but inflation rises by 3 percent. That's why many companies call an annual overall increase a "cost of living" increase; theoretically you aren't getting a raise; your increase in pay only offsets a loss in buying power from inflation.

All of which is why your investment returns need to outpace inflation. Otherwise you aren't really getting ahead.

3. If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same, or is there no relationship?

Answer: Fall.

The issuer of the bond promises to pay a set interest rate over a specific term. In effect, the buyer lends money to the issuer. Those bonds can then be traded by investors in much the same way stocks can. 

So if I own a 5-year bond that pays 5 percent, and interest rates go up to 6 percent... my bond is worth less than new bonds issued at 6 percent. Which means the value of my bond falls. Who wants 5 percent when they can get 6? 

That's why bond prices rise when interest rates fall, and bond prices fall when interest rates rise.

And is why, if I've bought a bunch of 6 percent bonds, in effect I'm betting that interest rates will fall so that my bonds will increase in value. Of course I also get the interest on those bonds... but why not double-dip?

4. A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage but the total interest over the life of the loan will be less.

Answer: True.

Say you borrow $200,000 to purchase a home. (To keep it simple we'll leave out homeowner's insurance, taxes, PMI, etc. and just focus on principle and interest.) 

If you get a 30-year mortgage at 4 percent, your monthly payment will be $954.83. After 30 years, you will have paid a total of $143,739 in interest.

If you get a 15-year mortgage at 3.5 percent (since interest rates on 15- vs 30-year loans are always lower), your monthly payment will be $1,429.77. That's $474.94 more per month.

But you will only pay a total of $57,358 in interest, which is $86,381 less than you will have paid on a 30-year loan.

That's because a 15-year loan pays off the loan principal at a faster rate; more of your monthly payment goes to paying off principal instead of paying interest, especially in the first few years of a loan. (During the first few years of a loan the vast majority of the payment goes to interest, not principal.)

All of which means that if you can afford a 15-year mortgage, you'll save a ton of money. That could mean buying less house. Or making different spending choices. Or, more likely, both. But if you can pull it off... the results are definitely worth it.

5. Buying a single company's stock usually provides a safer return than a stock mutual fund.

Answer: False.

A mutual fund is an investment pool that purchases securities. Think a basket of stocks; some mutual funds include stocks from tens or hundreds of companies. That helps minimize the risk from any one stock falling dramatically in price.

When Enron went bankrupt, its stock became basically worthless. If all of your savings were in Enron stock, you were devastated. But if you had shares in a mutual fund that included Enron stock, the value of the fund surely fell... but since it also owned a number of other stocks, it didn't fall that far.

That's why owning one stock is a riskier proposition: Sure, you can fully benefit from the upside... but you also face all of the downside risk. Which means you have to chose that one stock extremely well.

Which is really hard to do.

And is why Warren Buffett suggests investing your 401(k) in an index fund.

6. Suppose you owe $1,000 on a loan and the interest rate you are charged is 20 percent per year compounded annually. If you didn't pay anything off, at this interest rate, how many years would it take for the amount you owe to double?

Answer: 2 to 4 years.

People who thought it would take five years forgot about interest compounding. After one year you'll owe $1,200. After two years the 20 percent gets applied to that amount, which means you'll owe $1,450. And so on...

If that sounds complicated, here's an easy rule of thumb. Just apply the "Rule of 72" to any interest rate or rate of return: Divide 72 by the rate of return and the result is how long it should take your savings to double -- or, in this case, your debt to double.

So if you get a 10 percent return, it will take 7.2 years for the amount to double. Getting a 6 percent return will require 12 years. Getting a 4 percent return will take 18 years. 

Which means it will take 3.6 years, if you don't make any payments, for the $1,000 you borrowed to double.

And if that sounds a little loan shark-y, it is.

Correction: An earlier version of this column incorrectly stated the part of a loan that is paid down first: Initial payments go toward a loan's interest, not the principal.

Published on: Jul 25, 2019
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