Photo: Pictures of Money, Flickr
It's generally useful to be literate in at least one spoken and written language. But that's not the only kind of literacy that matters. We need to be savvy about managing (and growing!) our money, too. Here's a financial literacy test that will help you figure out where you are on the road to financial success.
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Answer the following questions without reading below them until you're done:
1. What is your net worth?2. Is it more important to pay off high-interest rate debt or save for retirement first?3. When should you start saving for retirement?4. How much money will you need to have accumulated for retirement?5. Do stocks, bonds, or real estate grow fastest over long periods?
Now let's review each question and what your answer reveals.
See how well you answer these five questions. Photo: Alberto G., Flickr.
What is your net worth?There isn't exactly a right or wrong answer to this question, though an answer of $0 or negative $100,000 would clearly be undesirable. Instead, the way to get this question right is to know what your net worth is, roughly.
Many people have no idea, because they haven't given much thought to the matter. But as you take control of your finances, and aim to build a comfortable future, it's important to have a handle on how financially healthy you are.
To determine your net worth, add all your assets together, including cash, savings and investing accounts, and the value of your home, car, and other belongings. Then subtract from that total all your debt, including the balance on any mortgage, car loan, or credit card account. What do you get?
Ideally, your net worth is positive -- and poised to grow. If it's negative, or lower than you want it to be, start figuring out how much money you have coming into your household, where it's all going, and what changes you might be able to make to boost your net worth.
Is it more important to pay off high-interest rate debt or save for retirement first?Tackling the debt should be your priority. With pensions having been phased out at myriad companies, it's more important than ever for us to save for our retirements. But don't do so while carrying high-interest rate debt, or you'll likely end up losing ground.
You can hope to earn close to the stock market's long-term annual average growth rate of around 10% with your stock investments, and that can turn a single $10,000 stub into almost $26,000 in a decade. But if you're carrying $10,000 in credit card debt and are being charged 25% interest, you can expect that balance to soar to more than $90,000 in a decade, if you don't pay it off pronto.
It's OK to maintain low-interest rate debt, such as a mortgage, while saving and investing for retirement; but debt with steep rates should be tackled as soon as possible. Otherwise, what you owe is likely to grow faster than what you own.
When should you start saving for retirement?The right answer here is as soon as possible. It's easy to assume that it's safe to put it off while you're in your 20s and even 30s, but that would be a big mistake. The later you start saving and investing for retirement, the more aggressive you'll have to be. If you start at age 45, for example, you'll have only 20 years to accumulate your nest egg, while someone starting at age 25 will have 40 years -- twice as long.
That's important, because the longer your money has to grow, the faster it can do so. Consider that if you save and invest just $5,000 per year, and it grows at 10% annually, it will become $315,000 in 20 years. That total wouldn't just be twice as much over 40 years -- it would be $2.4 million! If you sock away just $1,200 at age 18 and it grows at 10% for 47 years until age 65, it will top $100,000. Your earliest dollars have the most growth potential.
The sooner you start, the more your money can grow. Image: StockMonkeys.com.
How much money will you need to have accumulated for retirement?There's no one-size-fits-all answer here. You'll probably need to crunch some numbers on your own to arrive at a decent estimate.
For starters, note that, per many experts, a relatively safe annual withdrawal rate from your nest egg in retirement is 4% (adjusted for inflation each year), if you want your money to last. Thus, estimate how much annual income you'd like in retirement, and multiply it by 25 to determine how big a nest egg you need. Want $50,000 annually? Aim for $1.25 million.
Of course, you can also factor in Social Security income and any other expected income. (As of June, the average Social Security benefit was $1,335 per month, or $16,000 per year.) If you earn an above-average income, and assume an annual income of $22,000 from Social Security, then you'll only have to aim for $28,000 annually on your own, which would mean a nest egg of $700,000.
Do stocks, bonds, or real estate grow fastest over long periods?The answer here is clear, and it's stocks. If you don't understand how much you can expect to earn on various kinds of investments, you can leave thousands or hundreds of thousands of dollars on the table during your investing lifetime.
Check out this data from Wharton Business School professor Jeremy Siegel, who has calculated the average returns for stocks, bonds, bills, gold, and the dollar, between 1802 and 2012:
Source: Stocks for the Long Run.
The annualized rate for stocks from 1926 to 2012 was 9.6%, by the way. Stocks overpower bonds over both the long run and -- usually -- the short run. Siegel's data shows stocks outperforming bonds in 96% of all 20-year holding periods between 1871 and 2012, and in 99% of all 30-year holding periods.
Meanwhile, the research of Nobel-prize-winning economist Robert Shiller, famous for his studies of the housing market, has home prices averaging annual growth of about 5% in the post-war period since World War II.
Don't doom yourself to financial illiteracy. Keep reading and learning about smart money management, and your future may be much brighter. Give yourself a financial literacy test every now and then, too, to keep yourself on your toes.
The article Heres a Financial Literacy Test You Need to Pass originally appeared on Fool.com.
Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter,has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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