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