The average consumer thinks that banks make their money on the spread between the interest rate they pay to their depositors and the interest rate they charge their borrowers. We get so fixated on the rate of return, we don’t see what bankers see — that volume of interest and velocity of interest are the real wealth builders.
The Volume of Interest
Take a look with me at a $200,000 home loan at 6% over 30 years. By the time the homeowner pays that last payment, he will have given the lender over $231,000 in interest alone! That’s 115.5% of the $200,000 he originally borrowed, and is an illustration of the “volume” of interest that accumulates with the compounding process over time.
A good portion of that interest is collected up-front. So in the first five to seven years of a mortgage, the interest portion of the average house payment, though it gradually shrinks, never drops below 70%.
Refinancing every 5-7 years allows the bank to really capitalize on interest volume, since a re-fi simply resets the amortization schedule. At that point, house payments are again calculated with the highest ratio of interest to principal–beginning somewhere around 85-90% or more.
You can see that the rate of interest the banker charges is far less significant than the volume he ultimately collects. Your banker knows that, but most homeowners are still in the dark concerning this phenomenon.
Velocity of Interest
Interest is velocitized when money held on deposit is loaned out over and over again. Let me illustrate. Suppose an individual deposits $100,000 for one year, and the bank promises a 3% return. That $100,000 is now a liability, because the bank will have to pay $3,000 to the depositor at the end of the year.
So the banker finds someone he can loan the money to. The interest rate is not key here, but say the money is loaned to a seasonal business owner at 6% for three months. When that loan is paid off, another short-term $100,000 loan is made at 8%. The third quarter, that same $100,000 is loaned out again for 3 months at 4% . And, you guessed it, the final quarter of the year finds another businessman anxious to borrow the money at 10% for the three months remaining.
So, at the end of the year, using simple interest rates, the banker has made $28,000 in interest alone, plus closing and other handling fees that could total a couple thousand dollars or more. With the depositor’s money, the banker has grossed about $30,000, from which he pays his operating expenses, then happily hands $3,000 over to his depositor.
Even if the banker only charged 2% each quarter on each of the $100,000 loans, he would have accumulated $8,000 in interest plus fees and closing costs with an obligation to pay only $3,000 to the original investor.
Can you see why velocity of interest is where the real money is?
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