The Truth About Rates of Return: How Banks Make Money and More

how banks make money, ror, rates of return

Do you know the whole truth about how interest rates and rates of return work? Did you know borrowing money at 4% and investing at 5% is not a 1% difference but a 25% return? Yet this concept is how banks make money.

ates of return; how banks make money

While the jump from 4% to 5% may be a 1% spread, most people cannot identify the 25% return because we don't typically use financial calculators (like an HP-12c). If we do use them, it is still hard to tell what is going on because we can't see all the numbers at once.

That's why the set of 5 Financial Calculators exists as a part of the Truth Concepts calculator suite. Sometimes you just want a simple calculation, AND you want all the numbers visible, so it's easy to track the logic if you show it to a client. (Or, frankly, it's easy to retrace your steps when you open an old Tc data file.) This feature allows you to tell the whole truth about a complex idea in a simple way.

Let's unpack this concept about rates of return, and how banks use this concept.

How is Going from 4% to 5% a 25% Return?

To find out the rate increase, we'll want to pull up a Rate calculator from the Financial Calculator section. Then, we can input the variables that we know: that the Present Value is 4, the future Value will be 5, and we'll say that this change occurs over a year. This is because all interest rates are quoted as Annual Percentage Rates, so we measure interest rates over a one-year time period.

Rates of return, general

Since you're borrowing funds at 4% and earning 5% in your investment, that 1% difference represents a 25% improvement. After all, 1 is 25% of 4. If you were to do this math borrowing at 8% and investing at 10%, your return would still be 25%, as shown below. Again, because that 2% spread represents a 25% improvement. So a 2% spread doesn't really mean much, considering the ROR is the same.

2/8 equals 1/4 equals 25%.

Rates of return, general

If your client is having a hard time wrapping their head around this, have them think about it in terms of dollars. Say that you borrow $4,000 and invest it into a project. That project allows you to earn $5,000. After costs, your profit is $1,000, which is a 25% return on your initial investment. Interest rates work with the same logic.

How Banks Make Money

This simple yet misunderstood math is exactly how banks make their money. This one blows people's mind, and it proves that an interest rate alone means very little. It's the actual ROR that has an impact. Using two Rate calculators, let's see how drastically different one 6% spread can be compared to another 6% spread.

In our first Rate calculator, we'll represent banks in the 1980s. (Using the Title button, we've renamed the calculator). In the 80s, banks paid 9% on Certificate of Deposits, and charged 15% for consumer loans like cars and mortgages. As you can see below, that 6% spread was actually a 66.67% profit for those banks.

How banks make money, 1980s

When Alan Greenspan came in, he lowered the interest rates so that banks were only paying 3% on CDs. This helped them lower costs significantly. Because of the lowered rates, the banks could also afford to charge less interest on consumer loans, so they lowered lending rates to 9%. While people were certainly happy to pay less interest, this move also happened to explode bank profits. Their ROR went from 66.67% to 200% because their net profit was now 2x what it cost to offer CDs.

How banks make money, 1990s ROR

The spread may be 6, just like it was in the 80s, yet their return is multi-fold. And if the banks went back to 9% on CDs they'd have to charge 27% for loans to make the same profit. You can see this by using a Future Value calculator: if banks paid 9% (Present Value), and wanted to earn 200% (Annual Int. Rate), they'd have to charge customers 27% (Future Value). You can confirm this math by plugging 9 and 27 back into a Rate Calculator if you want the reassurance.

Bank ROR

Selling Hammers

When in doubt, go back to dollars. Say you own a hardware store. It costs you $9 to buy a hammer, and you sell them for $15. Your profit is 66.67% because you made enough to recoup your expenses, plus an additional 66.67%. If your wholesaler drops the price of hammers to $3, you can now buy 3 hammers for the price of one. This means you can now make 3 more transactions with customers for the same investment, so you extend that savings to them and YOU only charge $9.

In both cases, you're only making $6 per hammer. However, per a single investment of $9, you have the ability to either:

  • Net $6 by selling one $9 hammer at $15
  • Net $18 by selling three $3 hammers at $9

Unpacking the Truth About Rates of Return

This is not an easy thing to get one's arms or head around. Thinking about the numbers in dollars instead of interest rates can make it easier to grasp. Spending time with the Financial calculators can help you build your confidence around these calculations and how you're thinking about them.

The moral of this story is one must watch the cost of capital.  This is a subject corporations pay close attention to, yet consumers don't.  Many times we don't think our own money has a cost, yet it does.  And any time we are borrowing money we must be aware of the whole truth of all of the costs. To learn one of the best ways to compare a whole life internal rate of return with other assets, read our recent article.

Learn How to Use the Financial Calculators

For more insights on financial concepts and how to demonstrate them to your clients, attend a Truth Training. In this 3-day class, we'll cover how to use each Truth Concepts calculator, and what financial concepts you can demonstrate. This is the place to be to connect with peers and learn to better meet client objectives.