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