Interest – Earning Perspective

Today I’m going to write about Interest but instead of the usual cost of borrowing money I’m going to focus on the other side of the transaction. You can make money by lending money out. Traditionally that is where banks come into the picture. I’ll write a page specifically about how banks work in another post. For now let’s assume someone needs to borrow money and you have money to lend. The borrower assumes the responsibility to pay the interest on the balance of their loan. You are the lender so all of the interest the borrower is paying you is yours to keep. If you recall the credit card story with the average interest rate being 18.3% you can think of that as earning $0.183 for every $1 lent out. That is a great return on your investment considering on average the S&P 500 return is about 10%.

Great idea, but unless you’re Master Card or Visa you don’t the endless resources to be a direct lender. Instead as a consumer you’re likely to invest that money. The easiest way to earn interest on your money is to deposit that money in a bank. Interest rates have been at their historic lows for over a decade and as such the interest rate you’re likely to get from a Savings Account only .06%. That means for every $1 you have on deposit you’ll earn $0.0006. Less than a single penny. Moving to an online bank might score you an actual 1% return.

Another alternative is to buy a Certificate of Deposit. These instruments require you to leave the money invested for a fixed time period usually more than 3 months and less than 5 years. The longer the deposit term the greater the interest returned. There also could be a minimum amount required. National rates as of the time of this post are .06% for a minimum 3 month vs .39% for a 5 year term. As you can see the interest returned to an indirect lender is tiny compared to the cost of borrowing.

Yet another alternative which is much closer to direct lending is to buy a bond. Bonds are debt vehicles designed to provide borrowing entities substantial funds. Most people are familiar with Government Savings Bonds or Municipal Bonds. These instruments are usually long term, there are even records of government bonds lasting 100 years. I’ll go into more detail about Bonds in another post. Let’s just talk about the interest returned. Like CDs, Bonds require a minimum investment and a commitment to a long time horizon where upon maturity the bond holder gets their original investment back. Bonds usually pay interest twice a year but the interest is calculated each day. Interest rates with a bond is usually higher than CDs and may even have special rules. For example the government iBonds has its interest rate adjusted quarterly as inflation rises where as other bonds might even have an adjustable interest rate all together. Its also important to remember that bonds unlike savings and cds are not guaranteed investments which means if the borrower defaults you loose your investment.

Private Lending is another hot trend and provides the highest levels of return but also features the highest level of risk. Since you are lending money directly to another entity all of the risk of default falls on you. The benefit is that you can charge what ever interest rate you think is reasonable up to the limits set by States. Texas has an 18% weekly rate. As you can see the usury law limit is what the credit card companies charge. There are other ways to engage in Private Lending using a fund vehicle and investing in that fund. The fund managers, however, will charge a management fee which reduces the actual return of your investment.

In summary, its important to put your money to work for you. You don’t have to risk your money in the stock market to make money. Now that we’ve covered some of the interest bearing investment options let’s do the math. Assuming the following simple scenario:

Take $10,000 and buy a bond with a 5% coupon rate and hold that bond for 5 years. To calculate the interest amount you will earn over the 5 years divide the .05/2 since the bond pays semi annually. Multiply the periodic interest rate by the face value of the bond, $10,000 * .025 = $250. Each semi annual payment will be $250 so multiple the interest amount * number of payments 10 = $2500 is your return over the five years of holding the bond. While bonds are much more complicated, this simple example shows how you can make money just by having money. Amazing!