A few days ago, I met Dan, an old friend of mine and he made the impression to be in a good mood.
‘Hello Dan, you look happy.’
I said to him while we were shaking hands.
‘Well’, he replied ‘I finally managed to save some money’.
Dan explained, that after more than a year of starting his new job in construction, he opened a bank account for his accumulated savings of 1000 Euro.
‘How much interest per year?’ I asked.
‘2 percent’, he said with a smile.
If only Dan would have known about the inner workings of the financial system, he maybe would have been less satisfied with his 2 percent p. a.
Why? Because only minutes after Dan deposited his 1000 Euro, the bank took the money to lend it out for someone else who needed a credit and charged 5 percent interest p.a. for this customer.
So Dan makes 2 percent, the bank earns 3 percent (5 percent from the credit taker minus the 2 percent for my friend). And since the bank has also costs of 1 percent of the transaction, the bank remains with 2 percent net – the same figure as my friend. Most people would argue, that’s a fair deal between Dan and bank. But this is not exactly true.
The important lesson here is not only to see the nominal interest rate but to measure the interest with the invested capital. And here we see something else.
Dan invested 1000 Euro to get 2 percent or 20 Euro. The bank invested only the transaction costs of 1 percent or 10 Euro to get the same 20 Euro.
The bank doubled the investment within 1 year, while with 2 percent p.a it would take Dan a full 36 years to double his savings. (*)
Next time I see Dan, I will tell him about. Maybe his not so happy anymore. What Dan can do to earn more money, will be explained in the next chapter: www.theleader.ro/inflation/
(*) To find out how long it takes to double an initial investment, there is the “72-Rule”. Take 72 and divide it through the interest rate p.a. and you get the number of years it takes:
with 2 percent – 36 years
with 3 percent – 24 years
with 4 percent – 18 years
with 12 percent – 6 years