Think about the money you deposit in a bank. The bank
happily pays you interest from the day you deposit the
money. And the longer you agree to leave it there, the
higher the interest rate the bank is willing to pay. Did
you every wonder why?
The answer lies in what the bank does with your money after
you deposit it. You may say that the answer is very
simple; they lend the money back out at a higher rate.
That answer would be accurate but not complete. In fact,
they do not just lend your money out. They effectively
lend out up to TEN TIMES your deposit. They have the
advantage of LEVERAGE. The reason for this is that the
Federal Reserve Bank only requires banks to keep a portion
of their loans in reserve; currently 10%. As the bank
makes a loan, the loaned money is deposited back into the
banking system and a new loan is made. This happens
repeatedly until ten times the amount of the original
deposit is loaned.
So the bank is very happy to pay the 2% interest on your
loan when they will in effect be able to lend out ten times
the amount at, say 6%. So on your $1,000 deposit, they pay
you $20 and they earn $600. Not a bad return, considering
they are using YOUR MONEY. Of course, the more the bank
receives in deposits and the more loans it can make, the
greater its returns and profit.
Now, there's absolutely nothing wrong or evil with the way
banks make money. In fact, it is essential to an expanding
economy for the banks to create money in the way they do.
What most of us don't realize is that we can use the same
principles to expand our own money supply. We simply have
to apply these principles to our own investing.
What the bank does is use leverage, i.e., other people's
money and velocity, continually moving that money, to
continually expand their profit base. Individuals have the
same opportunities but many of don't realize it. A simple
example of compound interest can illustrate how individuals
can use the bank's money to increase their own wealth and
cash flow:
Suppose, for example, that an individual has $20,000 to
invest. Most investment advisors would tell that
individual to put the money in a mutual fund to receive the
"high" returns of the stock market. So, let's suppose the
investor follows that advice and invests the $20,000 in a
mutual fund. Let's say also that the mutual fund does well
and returns a 10% return every year for seven years and
that all income from the mutual fund is reinvested at the
same 10% rate.
At the end of seven years, the investor's $20,000 will have
grown to $39,000, or almost double the original investment.
Most investment advisors (and most investors) would be
very happy with this return. In fact, it would be most
unusual to do this well over a seven-year period given the
stock market's fluctuations. This result is actually a
demonstration of compound interest.
Now let's look at what happens if the investor instead uses
leverage to increase the return on that $20,000 investment.
For simplicity, let's use real estate for our example. We
could use other investment vehicles, such as business
activities or stock options, but we are all familiar with
how leverage works in real estate.
Instead of investing the $20,000 in a mutual fund, let's
suppose instead that the individual invested in a
single-family home. Let's suppose the investor puts down
10% on a $200,000 house (including closing costs). Let's
further suppose that the investor then rents the house for
an amount equal to the monthly mortgage and maintenance
expenses of the house. Then, let's say that the house
appreciates at an annual rate of 5%.
At the end of seven years, the house will be worth
$281,000. The investor's $20,000 will have grown to
$101,000, or roughly 2.5 times the return from a good
mutual fund. It's probably safe to say that this is a
considerably better result than the mutual fund. This
result occurs because of the principle of LEVERAGE.
The investor in this case received not only the 5%
appreciation on the original $20,000 investment, but also
received 5% on the bank's loan of $180,000. Of course,
many real estate markets are currently appreciating at a
much higher rate than 5%, so this return could be
unrealistically low. But the average appreciation in real
estate over the past several decades has been around 7%, so
5% is a nice, CONSERVATIVE, example.
You may now be thinking that this whole idea of leverage is
great and earning $81,000 on a $20,000 investment over
seven years would be terrific. The problem with this is
"IT'S STILL TOO SLOW." We can still do much better.
Besides leverage, we need to add the principle of VELOCITY.
For more on Velocity, please see my article: "The Fast
Track to Your Financial Freedom (Part 2) - Adding Velocity
to Your Investments".
Warmest Regards,
Tom
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Tom Wheelwright is not only the founder and CEO of
Provision, but he is the creative force behind Provision
Wealth Strategists. In addition to his management
responsibilities, Tom likes to coach clients on wealth,
business, and tax strategies. Along with his frequent
seminars on these strategies, Tom is an adjunct professor
in the Masters of Tax program at Arizona State University.
For more information, visit http://www.tomwheelwright.com
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