How Banks Create Money
Most consumers do not bother to know about what happens when they drop off their cash with a banking institution. I can tell you that banks are proud of this fact because the lesser consumers know the lesser challenging banks create money even more easily.
Imagine if you had someone you could just go to and ask for money and they’d just hand it to you without a question. Wouldn’t that be wonderful?
But because that is not the case, that is why customer service skills are a key to make sure banking institutions still get that money out of us efficiently.
In this article, we are going to explore how banks create money and how you, on the other hand, can act the same way they do to create money as well. This is so possible especially if you are an investor or a homeowner.
We’ll see how a homeowner can use that knowledge of how banks create money to replicate the same thing in their favor. In the effort of learning how banks create money, we’ll look at :
How banks create money on consumer facing edge
How banks create money on plastic cards
How banks create money on loan
How a consumer can create money on home equity
How a consumer can create money from loan amortization saving (what banks do not want you to know)
How a consumer can create money on interest rate
How Banks Create Money in Investment
Banks participate in the stock market just like any other investor. They also borrow money
from other banks to balance their cash reserve.
But importantly, banks invest in commercial buildings such as mall buildings or high rise office buildings.
Why does anyone else need to know this? Because if you are an investor they become either your competitors or your partner.
How Banks Create Money On Consumer Facing Edge
Banks Create Money from fees and loans they offer. Fees such as returned check, check books, monthly maintenance, insufficient balance, money transfer between accounts(based on allowable number of transfers per calendar month), etc, are from servicing your account to those associated with a loan offer.
Loans related fees could be: origination fee, interests, and loan fees or otherwise technically referred to as points.
Usually the bank that originates your loan is not necessarily the one that is going to service the loan. This is mostly for home loans. Other Loans such as personal, vehicle and boats are kept by the bank on their portfolio.
Mortgage loans however are sold on the secondary market in the form of securities or stock. The guy who writes your home loan or a mortgage broker that repackages many loans into a unit and sells it as one instrument on the secondary market.
How banks create money on this is on the difference of interest; the interest set by the secondary market, which is lower compared to the interest they changed you, which is higher.
Therefore they keep the difference. This is also to say that the higher the interest they charge you, the more money you help them create. Where they do not lose it in the fact that the bank or mortgage broker knew what the interest was before shopping for the mortgage.
It is like the market sent them to bring mortgages for instance for 1.5%, but they got it at 3.5%. Therefore, they are taking the package of mortgages that they have collected at 3.5%. They get to keep the excess 1.5%.
This is different from shopping for a commodity, which you pay $5 only to get $3 when you sell it back. Rather, it is like this: Someone gave you money to sell his bike for $3, luckily you got a customer that is willing to buy it from you for $5.
You return the $3 you were asked to bring and keep $2. Plus probably a service for doing the selling job for him, say 20cents. In the end, you bring back to him $2.80.
How banks create money on this model may seem confusing but, remember that if the secondary market’s rates are set to 2%, and the bank brought a mortgage that has 1.8%, This would be a loss because the secondary market will not even buy it.
Because, the interest rate is how much the consumer will bring in. So, if it is lesser, the bank may not even be able to sell it. And it that happened, they’d be stuck. The same is if they kept the mortgages on their portfolio.
Will they have wait for 30 years to make another loan or money? No. The only way to keep creating money is if they had another way to get cash. That is what reselling the loans accomplishes.
Why do consumers want to know this because interest rates are not the same across the board
This is why you need to shop for it with at least three different institutions. We will see below how a higher interest can benefit a consumer as well.
How Banks Create Money on Credit Cards
The rule of thumb is that whatever a banking institution encourages you to go for benefits them more than it does for you.
For credit cards any merchant who accepts the card pays a percentage to the issuer. That percentage may not be a lot but it adds up. Let’s say that every marchant pays three cents per swipe, how many people swipe their card per day? Say one million?
This is just for the math purpose because there is a large number of transactions per day per bank. For that example alone you see that the bank cashes in $30,000.00.
For the consumer, the only benefits are the convenience of not having to carry cash, credit building and probably bonuses or cash back. With a great goal setting and the right discipline, you can still do more with credit cards
Does this mean that credit cards are not important for a consumer? That is not my focus. You can actually do more with a credit card. Increased limit can be a source for capital as long as you are disciplined well enough to manage it effectively.
How Banks Create Money on Loans
We already discussed fees on loans. The most important idea here is that each time a comsummer asks for a loan before even the collection of fees they have created money for the bank already.
If you take a vehicle loan for $100,000.00 that is to be paid at 5% for five years, the loan will cost the consumer $5000. That is to say that by accepting a loan the bank just created $5000 out of nothing.
If we suppose that the bank had only that loan amount as their reserve, it would have sat there with no increase to be made. But this time it has increased by $5000.
When we talk about how banks create money, it should not be construed to say that they launder money. The money is simply made available by the promise to pay the agreed upon interest amount by taking advantage of their loaned amount.
Graciously, consumers can position themselves like a bank if they wanted to. The most important investment asset that most american for example will be able to own in a lifetime is a home.
Now, to tell you the truth here, not every home is an asset; at least not at every stage of ownership. However, if you look at it as an investment, it can as well be. You can find more resources on how to determine an asset from a liability here. This is when you leverage your home for a capital tramplin.
When you look at your house as an investment, you are not eyeing at where it is standing, but rather, how much equity it has accumulated and what you can do with it. If the goal is to reinvest the equity, not buy consumer products with it, now you home can really help you big time.
How Consumers Can Make Money Through Equity Growth Acceleration, Amortization and Higher Interest Rates.
There are many ways one can utilize to accelerate a mortgage repayment. I am not talking about payoff here because we will see that paying off your mortgage may not be the best financial decision.
We want to think like a bank which will want to make money for ages nonstop. What is the problem of paying off your mortgage early? One is that you will then have a lot of cash sitting in your house doing nothing.
Imagine you have a $300,000.00 worth of house paid off. That is to say that you have at least $270,000.00 that you could be investing sitting in your house and paying taxes on top of it. Is that great?
The only way you can have access to that money will be to sell or take out equity through a Home equity line of credit (HELOC) or refinance. Refinancing reminds you that you should have not poured in the money in the first place.
If you were able to have all that money to pay it off, you could have directed it towards the investment that you want to do this time. Why then did we talk about acceleration in the first place?
We want to recoup most of the interests that would otherwise go to the bank. And when the portion that goes towards the principal is then greater than the amount of interest in one payment, then we can stop the acceleration and direct the money we’d put towards the principle to doing other sorts of investment.
That way, we do not have to refinance or borrow money again.
It is flipped starting with a larger portion going to the interest. In the mid journey, marked M, they start to flip back, with a larger portion going to your principal this time.
When your payment schedule reaches S, for Stop, you can actually stop accelerating the payment. And apply your acceleration amount towards another investment. You will be surprised how fast you can actually get there.
When you constantly apply money on the principal, it cuts down a lot of years and gets you back all the interest you could have given to the bank. Therefore, you are then the bank. You are creating that money the bank would have created.
At this time, the higher the interest the higher you get back. You see, higher interest is not all bad after all. Most of the time, the amortization schedule that is given out to consumers does not show the total interest taken per the next payment. It only shows you the interest taken per that payment.
You can check online in the mortgage calculator with one that shows how much total they will have taken per your next payment. It’s a lot and that will give you the motivation to want to keep it in your pocket.
Banks do not want you to see that column. By the way, I checked back on the calculator that I used last year only to find out that they have also removed that total column. But because I saved the amortization schedule, look at the picture below
The first number is the payment, the second is the principal, the third is the interest, and the fourth is the total amount of interest the loan will have cost the consumer by that time. Also, you can see that numbers are starting to flip.
The amount applied to the principal is going to be higher by the following payment. I used to use the Bankrate mortgage calculator.
It is no longer showing that total option. The calculator could estimate how much you gained once a certain lump sum was added to the principal.
Is there any other benefit of a higher mortgage interest you could think of? Please share!