If someone offered you one million dollars now or the ending balance of one penny, doubled every day for a month, which would you choose? Many people would opt for the million bucks, but they’d have left almost $10 million on the table ($9,377,418 to be exact). This is the power of compounding which Albert Einstein called the eighth wonder of the world.
This exercise is very interesting, yet this isn’t often taught in high school. The same scenario faces students in 60% of states whose high schools do not required students to take basic economics or personal finance courses.1 This is worrisome because we know that throughout the course of people’s lives they will encounter many financial decisions and choosing the wrong ones can place you at a disadvantage financially and take years and years to dig out of. The main topics discussed in personal finance courses typically revolve around how to open a bank account and balance your checkbook, understanding interest payments, and the positive power of compounding in investments.
Financial literacy pays off. A study released last month by the Financial Industry Regulatory Authority’s ‘Investor Education Foundation’ showed that high school students who had mandatory financial literacy classes went on to have better average credit scores (FICO scores) and lower debt delinquency as young adults.
Good FICO scores are important because this determines the rate of interest you’ll pay on everything from cars, houses and school tuitions.
There was a notable improvement for young adults, ages 18-22, in three states specifically, Texas, Georgia and Idaho where the financial literacy standards are rigorous. Idaho requires a full year and a half of courses on the subject. In Texas, the students are actually tested on the material for grades and in Georgia the teachers must also be trained in order to teach financial topics.2
In Texas, the young adult’s credit scores rose a whopping 32 points, or 5.2%.3 This is important not only for the ramifications for future borrowing costs and availability but also for job prospects, as employers are increasingly looking at credit backgrounds during the hiring process. What employer would be willing to give an applicant a career in finance if they have demonstrated that they haven’t personally demonstrated an understanding of finance in their own lives?
One of the most important things that should be taught is the difference between simple and compound interest. Also, understanding the lingo used in these terms such as revolving credit or, aptly named, revolvers.
The most important thing that a financial literacy class teaches you might be that you want to use the power of compounding interest for you (in investments) and not against you (in debt). Compounding can be brutal on people’s financial situation and many people could have avoided serious financial hardships with simple lessons.
Simple interest is just the interest rate multiplied by the loan’s principal multiplied by the time periods. A $1,000 loan at 5% for two years totals $100. But more often, compound interest is used in the real world. With compounding interest, the interest accumulated gets added to the principal so the next interest calculation will include a higher principal and the cycle continues.
In a nutshell, simple interest is only paid on principal but compound interest is paid on principal plus all interest that’s accrued. Let’s take a look at the Good, the Bad and the Ugly of what can happen to students when they graduate high school and start encountering common financial situations.
The Eighth Wonder of the World
The power of compounding is incredibly powerful. According to Vanguard, an investment of $10,000 can compound at a relatively conservative 6% (with all earnings and dividends automatically reinvested, any brokerage account can easily do this for you) and grow to $102,857 over 40 years, a tenfold increase.4 So if you start a retirement account once you start working right out of college (or even from a part time job in high school), you’ll be in great shape later in life. And the great thing is you don’t have to do anything aside from the first deposit! As long as you can choose a low-cost index fund, you should enjoy these gains. Don’t forget, time is on your side.
Opening a Bank Account
Opening a bank account and monitoring the debits and credits is a basic but essential accounting skill that can keep consumers out of a lot of trouble. This used to be called balancing your checkbook, but that is so last century. A checking account is how most people pay their bills these days (on time hopefully) and increasingly how people get paid (direct deposit).
Monitoring your balances properly can avoid overdrawing on the account (spending more than you have). Overdrawing on your bank account results in bounced check fees, overdraft charges, and embarrassment so keep your transactions recorded. With today’s paltry interest rates on checking or savings accounts, you could end up paying more in fees than you collect in interest. That’s not a good trade-off.
Don’t Get Taken for a Ride
Some car dealerships take advantage of young, naïve buyers. A school’s personal finance program can teach students that today’s auto dealers make their money on the car’s financing, not as much the sticker price. Today, auto loans are often extended out to seven years which has the ability to mask higher interest rates and other fees. Young buyers are often more concerned with one number, the monthly payment. They are called payment shoppers and the dealerships love them (just like credit card companies love the minimum payment payers-it’s the same concept). Buyers should be focusing on another number- the total amount paid for the vehicle (including interest).
Consumers should be aware that some dealerships and their third-party affiliated lenders implement a “markup” for certain, often minority buyers. A report by the Center for Responsible Lending reported dealer markups made in 2009 auto loans cost consumers an additional $25.8 billion over the life of the loans.5 The CFPB has also come down on this area but it probably can’t be policed fully so consumers need to be aware of the practice. These higher fees are allowed because of poor credit scores.
The power of compounding can also work against you, especially if you aren’t careful using a credit card. Credit cards employ revolving credit which is compound, not simple interest. Credit card companies know many young people aren’t aware of how this works which is why they prey on those experiencing their first taste of freedom, college students. Students no longer have mom and dad around to constantly say no. But freshmen who have had financial literacy education are much more likely to avoid the temptation which can get them into trouble.
Annual Percentage Rates, APRs, on credit cards can really skyrocket if you get behind on payments often range from 10%-29.99%. If you buy a big screen TV for tonight’s Super Bowl for $1,000 with a credit card it will take you almost seven years to pay off that balance if you only pay the minimum payment. This is what the credit card companies want you to do and you’ll be paying lots of interest. If you want to avoid interest, pay off your balance every month.
People with basic literacy know to avoid the payday loan debt cycle that traps many young people just starting out. Some of these payday loans effectively have between 300% and 500% annual interest rates!6 Eventually people obtain payday loans to cover prior payday loans and on and on…. The Consumer Finance Protection Bureau or CFPB revealed in a recent report that roughly half of all consumers that use payday loans end up using the service ten times or more.7 Even though payday lending is banned in a number of states, there are often ways to circumvent this.
We hope that financial literacy is taught more in America’s high schools and if it isn’t offered in your state, try online resources such as PracticalmoneySkills.com which has a wealth of information on financial literacy for high schoolers.8