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What is your personal finance IQ? Find out by taking the following true or false quiz. 1. Surveys indicate that a high proportion of Americans feel financially insecure. This insecurity is primarily because the incomes of Americans are low. False. The average income of Americans is currently the highest in history. The insecurity results from bad choices, unsound financial planning and low savings rates. 2. Financial success is primarily the result of setting long-term goals and developing a plan to achieve them. True. Setting goals and developing a plan to achieve them is the foundation for sound personal finance. 3. If you are going to increase your wealth, it is vitally important for you to allocate funds regularly into savings and investments. True. Allocation of a sizeable portion of your income into saving and investment is a key to building wealth. Most financial experts recommend that people save and invest at least 10 percent of their income. Automatic payroll deductions into a savings/investment account can provide discipline in this area. 4. If you have $50,000 of outstanding debts and the market value of your assets is $30,000, your “net worth” is negative $20,000. True. Net worth equals assets minus liabilities. 5. The purpose of a budget is to increase awareness of how funds are spent and to help the individual or household develop a plan to control spending more effectively and save for the future. True. A monthly budget will help you control spending and make regular saving and investment a permanent part of your lifestyle. 6. It makes sense to allocate funds regularly into a special savings account so you will be better able to deal with future surprise expenditures. True. Everyone will incur unforeseen expenditures; the only surprising element is when they will occur. 7. Corporate stock investments are a particularly attractive method to save funds for unexpected future expenditures such as those associated with auto repairs and health problems. False. Funds for a potential emergency need to be easily convertible to cash at a predictable value. The short-run value of stocks is volatile and, therefore, you do not want to have to sell them at an inappropriate time. 1 8. When purchasing a house, you will often be able to bargain for a lower price and arrange a loan at a lower interest rate if you are able to make a sizeable down payment (for example, 20 percent). True. The down payment reduces the risks confronted by both the seller and mortgage lender. This will increase the buyer’s bargaining power. 9. It is costly to purchase a new car every two or three years because new cars depreciate rapidly during their first few years of use. True. During the first three years, new cars typically lose 40 to 50 percent of their initial value. This depreciation increases the cost of regularly purchasing a new car. 10. If you can afford the monthly payment, you will be able to save money by purchasing a new car rather than a used one because the maintenance cost will be lower for the new car. False. The depreciation costs will almost always be higher for the new car, and this will generally more than offset the higher maintenance costs of the used car. 11. When auto dealerships or furniture stores offer zero-interest financing for 36 months, you will be able to save money by purchasing from these sellers. False. Sellers often use zero interest financing as a marketing device, but the lower interest rate charges are generally built into their selling price. In essence, the “cost of financing” is incorporated into the sales price of their goods. 12. If you make the minimum monthly payment on your outstanding credit card balance, you will not incur any interest charges. False. You will be charged an interest rate, and often a high rate, on the unpaid outstanding balance. 13. If your credit card balance is well below the limit, you do not need to save for emergency expenditures because the unused borrowing power on your credit card is like funds in an emergency savings account. False. Unlike an unused credit card limit, funds in a savings account are an asset. Further, it will be more economical to use savings to cover unexpected expenses than to borrow the funds via a credit card. 14. The use of credit cards to purchase and finance spending on items like food, clothing, and entertainment is highly likely to lead to serious financial problems. True. Nondurable consumer items like these have virtually no value after they are purchased. Use of financing to purchase them will reduce your wealth and lead to financial difficulties. 2 15. The interest rates charged on outstanding credit card balances are usually quite low because these loans are highly secure. False. Credit card loans are unsecured and, therefore, risky. This is a major reason why interest rates on credit cards are high. 16. Saving, and the power of compound interest, can make it possible for you to consume more and achieve a higher living standard in the future. True. Funds saved will grow in value which will make higher future consumption possible. 17. If you have funds in an investment account earning a 10 percent average annual rate of return, it will take approximately 7 years for the funds in the account to double. True. The rule of 70 indicates that 70 divided by the rate of return will approximate the number of years it takes a value to double. In this example, 70/10 indicates this investment will double in 7 years. 18. Corporations are required by law to pay a specified dollar amount per share to their common stock shareholders each year. False. Some corporations may pay dividends to shareholders, but there is no obligation to do so. In fact, the initial investment may not even be returned to the stockholders. In contrast, entities issuing bonds are required to pay bondholders a specified rate of return, along with the principal, when the bond matures. 19. The administrative costs of managed equity mutual funds will generally be lower than for indexed equity funds because managed funds typically spend less on research and stock trading than indexed funds. False. The administrative costs are higher for managed equity mutual funds because fund managers spend more on both research and stock trading. Indexed funds spend little on these items because they merely hold each stock in the same proportion as its representation in a major stock index such as the Standard and Poor’s 500. 20. Historically, the rate of return on a diverse holding of corporate stocks has been higher than the return derived from low-risk bonds. True. Over the last hundred years, the nominal rate of return on stocks has been approximately 11 percent, compared to 7 percent for bonds. 21. Diversification of one’s portfolio is important for the reduction of risk because the value of a narrow set of assets may change dramatically over a short period of time. True. Diversification reduces risk. For example, the value of corporate shares (or shares of companies in the same industry) may change substantially relative to the broad stock market. Consider Enron. 3 22. An indexed equity mutual fund will provide shareholders with a return each year that is exactly equal to the change in the consumer price index during that year. False. The stockholdings of an indexed fund mirror the S&P 500 or another broad stock market index. Neither the return nor the composition of these holdings is related to the CPI. 23. An unexpected increase in the rate of inflation will tend to reduce the market value of outstanding bonds yielding a fixed nominal interest return. True. The higher inflation rates will lead to higher interest rates, which will depress the value of outstanding bonds paying lower rates. 24. As people approach retirement, they should invest a larger share of their retirement funds in stocks and a smaller share in bonds and other fixed return assets. False. A diverse holding of stocks has yielded attractive returns with low variability when held over lengthy time periods like 25 or 30 years. However, over short periods such as five or even ten years, the variability of stock holdings is relatively high. Thus, as retirement approaches and funds will be needed for spending, it is prudent to switch from stocks to bonds. Treasury Inflation Protected Securities (TIPS) and other less risky investments will vary less in value over a shorter time frame, on average, and therefore you can count on the funds being available in the near future. 25. If career objectives may cause you to move from an area during the next two or three years, you should purchase a home if your mortgage payments are less than your rental costs. False. Houses are illiquid assets, and there are substantial costs associated with their purchase and sale. When a person is likely to move in the near future, these costs will generally overwhelm any savings derived from lower mortgage payments relative to rental costs. 26. A history of late payments on credit cards, a defaulted car loan and an unstable employment history will adversely affect your credit score. True. All of these factors reduce your credit worthiness and therefore your credit score. 27. Tax saving plans such as a traditional Individual Retirement Account (IRA) will reduce your current tax liability and allow you to earn a higher return than would otherwise be possible in the long-run. True. Funds allocated into these accounts can be subtracted from your current gross income which will reduce your tax liability in the present and help you earn a higher rate of return on retirement. 28. If it is possible to earn an interest rate of 7 percent, the cost of spending $4 per day on a premium cup of coffee over a 40 year period will be more than $300,000. 4 True. At a 7 percent return, $4 a day or $360 per quarter will yield approximately $313,147 when compounded quarterly over 40 years. This highlights that seemingly minor reductions in current spending and increases in saving can have a huge long-term payoff. 29. Your take home pay will be less than your gross earnings because of taxes and benefits provided through payroll deductions. True. Take home pay equals gross earnings minus taxes and other deductions. 30. If you want to avoid financial anxiety, it would be wise to gradually increase the outstanding balance on your credit cards to their credit limit. False. Whether done gradually or quickly, pushing credits to their limits is a sure way to produce financial anxiety. 5 Determine Your Personal IQ Score and Grade 27-30 A 24-26 B 21-23 C 18-20 D 0-17 E You are a personal finance super genius! Enjoy your life of wealth and prosperity. Above average personal financial IQ. You are on your way to riches! Average personal financial IQ. You have a good foundation but could benefit from some financial training. Below average personal financial IQ – You could definitely use some financial training. You desperately need financial training to avoid future difficulties. It’s a good thing you are in this class! 6