The following simple finance questions were asked by two economists, Annamaria Lusardi and Olivia Mitchell and reported in the Atlantic and 70% of Americans could not get all 3 questions correct:
- Suppose you had $100 in a savings account and the interest rate was 2 percent 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; D) do not know; refuse to answer.
- Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After one year, would you be able to buy A) more than, B) exactly the same as, or C) less than today with the money in this account?; D) do not know; refuse to answer.
- Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.” A) true; B) false; C) do not know; refuse to answer.
The correct answers are 1-A; 2-C; and 3-B.
Only 30% of Americans could answer all three of these questions correctly. Most people think they know more than they do when it comes to finance. I think people should know the basics of inflation (#2) and 2 basic rules about inflation for their personal finances.
- When you’re planning for the future, don’t forget about the effects of inflation.
- Don’t hate your mortgage if it is fixed and has a good rate. It’s got some upside!
Inflation makes your money able to buy LESS stuff in the future than it can buy now. That’s why a dollar is worth more today than in the future. Interest, on the other hand, means that your investment grows because someone is paying you to use your money temporarily.
Why does this matter? If you put your savings in a low interest account or bond that doesn’t make at least enough interest to cover inflation, then your hard earned money will actually be worth less when you take it out than when you put it in. It has eroded. This matters a lot when it comes to retirement or savings planning (rule #1).
When you calculate returns on your savings, meaning you plan on having more money later than what you put in due to growth or interest, you have to remember your return will be decreased by inflation. That’s why answer C is correct for question 2 (again, rule #1).
People fear high inflation because wages may not grow at the same rate as inflation and then it feels like you’re being paid less because your money does not buy as much. They keep working and can’t buy much. That’s why inflation feels bad.
The good news: some things can actually protect you against inflation like your 30 year fixed rate mortgage (or any long-term fixed rate debt). Why? You are paying your debt back with dollars that are worth less. In effect you’re paying LESS for your mortgage in higher inflation because the worth of your payment (the basket of goods you could buy with your payment) shrinks (rule #2).