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How to Raise Your Child's Financial IQ

Here are five lessons to help kids increase their knowledge about personal finance.

First, the good news: Americans are having an easier time making ends meet and are more satisfied with their personal finances than they were three years ago, concludes the 2012 National Financial Capability Study sponsored by the Finra Investor Education Foundation. However, 56% of those surveyed have not set aside enough to cover three months’ worth of expenses in a rainy-day fund, only 41% spend less than they make, and just 14% were able to answer correctly a series of five questions on financial literacy. (For more on the study, see Are Americans Getting Smarter With Their Personal Finances?)

One significant finding is that younger Americans have not fared well. In the three years since the previous survey, respondents between the ages of 18 and 34 were more likely than older respondents to have experienced a drop in income. In addition, young adults were more likely to overdraw their checking account, be underwater on a mortgage, take a hardship withdrawal from their retirement account and require financial help from family members. They were less likely to be able to come up with $2,000 in an emergency. Plus, 54% of those who have student loans are concerned they might not be able to repay them.

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To top it off, young people scored much lower on the five questions designed to measure financial literacy. On average, they got 2.3 questions right, compared with 2.9 correct answers for 35- to 54-year-olds and 3.3 right answers for people older than 55. Overall, the study concluded, younger Americans “are at a pronounced disadvantage on nearly all measures of financial capability.”

Raise your financial IQ. A lot of this reflects lower incomes, lack of life experience and higher levels of unemployment among the young. There are no quick fixes for those conditions, but I’ll take a stab at boosting financial literacy.

For younger children, I’ve recommended a number of hands-on money skills that kids need to master before they leave home (see 4 Ways to Make Financial Literacy Work). The Finra study’s questions were geared toward the 18-plus group and tested knowledge of five concepts: interest rates, inflation, mortgages, investment risk and bond prices. Here’s a crash course to pass along:

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-- Fewer than half of young respondents knew that if the inflation rate exceeded the interest rate on their savings account, they’d be able to buy less in the future. Lesson: Inflation hurts your purchasing power.

-- Most respondents knew that their savings-account balance would increase over time if they were paid 2% interest each year on an initial deposit of $100. Three-fourths of those questioned got that right. Lesson: Small amounts can grow into big piles, thanks to the magic of compounding.

--Young people who are considering buying a house should know that the monthly payments on a 15-year loan will be higher than on a 30-year loan, but the total interest paid will be less. Lesson: Traditional 30-year mortgages generally make more sense for first-time buyers because they require lower monthly payments, but it’s important to lock in the best deal on a rate to minimize interest.

-- Fewer than half of those surveyed knew that buying a stock mutual fund is less risky than buying an individual stock. Lesson: There are no guarantees, but good funds are generally less risky because you’re not putting all your eggs in one basket.

-- Only 43% of investors and 22% of non-investors knew that when interest rates rise, bond prices fall. Lesson: Bond prices and interest rates always move in opposite directions. That’s because new bonds issued at higher rates are more attractive than old bonds at lower rates, and vice versa.

There. Now you and your kids have increased your knowledge exponentially. To take the quiz yourself, go to www.usfinancialcapability.org.

Footnote: When asked whether they thought financial education should be taught in schools, 89% of those surveyed said yes.

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