Tuesday, December 23, 2008

The Rule of 72 is Cool!

When people invest money, they do it so they can make money. That’s called "getting a return on your investment.” Sometimes they want to know how long it will take to double their investment. To do this, we use the Rule of 72.

Take 72 and divide it by the amount of return on your investment. That is the number of years it will take to double your original investment.

For example: Ten year-old Keanu buys a bond for $10,000 and earns 6%. 72 divided by 6 = 12. So every 12 years, Keanu’s money doubles. When he is 22, he will have $20,000.

What if Keanu leaves that money alone until he retires at 60 years old? His money will double 4 times by then and he will have $160,000.

Let’s say Keanu used that original $10,000 and bought a stock that earns 12% return (72 divided by 12 = 6) he will have $20,000 in 6 years when he is 16. If he leaves that money alone until he retires, it will double 8 times and he will have over $2.5 million when he is 60 years old.

The Rule of 72 is based on a principle called “compound interest” (return), which is sometimes called “The 8th Wonder of the World”! I’ll explain more about compound return in my next post.

Here’s something VERY important to remember. Just because things happened in the past, doesn’t guarantee they’ll happen in the future. So we use historical return rates as an example. It doesn’t mean that if you invest in the stock market today, that you will receive 12% return on your investment every year. Also, when investing in stocks it is possible to lose money, so that the value of the stock could be less than the original investment.

Wednesday, November 12, 2008

How Do Banks Make Money?

When my oldest son was 4 years old, he said to me, “Hey Daddy, we need some more money so let’s just to go to the bank and get some.”

You probably already know that’s not how it works. You have to put money in the bank before you can take money out.

Banks are businesses that hold money for people like you and your parents. When you give them money, that’s called a deposit. What do you think they do with it? They loan that money to other people. They pay you interest to be able to use your money. The people who borrow the money have to pay interest to the bank for lending them the money. The bank charges the people who borrow the money a higher rate of interest than they pay to you. The difference between what they make and what they pay you is income for the bank.

For example: When your parents bought their house, they went to a bank to borrow the money. Now the bank owns the title to your house and your parents make monthly payments to the bank in order to pay back the bank for the money they borrowed.

Where did the bank get the money to loan your parents? They got money from all the people who deposit their money in the bank. The bank tells these people, “If you let us use this money, we will loan it to other people who need it – and we will pay you for allowing us to do this.” Let’s say the bank pays them 2% interest. To the people who borrow the money, they say, “We will lend you money but you must pay us interest to use that money.” They charge these people 5%. The bank makes 3% on that money.

So if you borrow money from the bank, you must pay the bank back for the entire amount you borrowed, plus you also must pay an extra amount called interest.

Come back next week – and bring your friends. I’ll explain more about interest.