All throughout April, we’re posting educational financial literacy content in honor of national Financial Literacy Month.
One of the key financial literacy topics that people don’t readily grasp is calculating interest. Many of us are fine with basic math, but when it comes to estimating gains or costs associated with interest rates, we struggle.
A common question on financial literacy tests goes like this:
You put $100 in a bank account that earns 2% interest. How much will you have in that account after 2 years?
- A.) less than $102
- B.) $102
- C.) more than $102
About half of respondents will answer incorrectly. The answer is more than $102. After 1 year, the account earns 2% of $100 in interest, or 2 dollars. ($100 x .02= $2)
In the 2nd year, the account earns 2% of $102, or $2.04 ($102 x .02=$2.04)
That means the account has $104.04 in it at the end of year 2, so the answer to the above is c.
Moving forward, the interest keeps compounding. The third year you calculate 2% of $104.4, the fourth year $106.5, and so on. This is why it’s crucial to save early and leave your savings alone to grow. Every year the balance goes up, and the interest is calculated against the new, higher balance.
Rule of 72
Following on the compounding interest topic, we come to the Rule of 72. This is a quick way to approximate how fast a balance will double. The math is simply 72 ÷(annual interest rate, compounded). So in our above example, if you had $100 in the bank earning 2%, how long would it take the money to double?
72 ÷2=36. It would take 36 years for your $100 to double if it’s earning 2% interest.
This works in reverse as well. If you owe someone $1,000 at 12% interest, how long will it take your debt to double if you don’t make any payments?
72÷12= 6. In six years, you will owe $2,000 on the original debt of $1,000 if you make no payments.
Don’t forget compounding
The basic mistake most people make is leaving out compounding. We do quick math in our heads—2% of our $100 savings is 2%, so we earn $2 per year. By that logic, we’d have to wait 50 years before our initial savings doubled. But it only takes 36 years, due to compound interest.
We hope we didn’t overload you with too much math in this post! If you remember the rule of 72 and don’t forget compounding, you’re already more financially literate than you were yesterday.