How Lenders Make Money
Banks are simply like other businesses. Only that, their product is money. You know, other businesses sell physical products or service- while banks sells money (in the form of money and other financial products). They make money on the interest they charge loans because the interest is always higher than the interest they pay on depositors' accounts.
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Today, in all parts of the world, most banks work this way: borrowing money from depositors at one rate of interest, and lending the money out again at another, higher rate of interest. Then, they pocket the difference.
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You and I might think that makes bankers really selfish. Since they pay measly rates of interest to their depositors and charge higher rates to people who want to borrow from them. And In the end, they’re firmly focused on making a profit for themselves and their shareholders. The loans they make are a way to make that money.
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Now let us see how lenders creates money. And we will still use banks as our case study.
How Lending Creates Money Out Of Thin Air!
One Monday, Mr. Alex entered his bank and deposits 1 million Naira. After he left, the bank put 10 percent (100,000 Naira) in reserve, just in case Mr. Alex wants some of his money quickly.
The next day, Mr. Ade entered the same bank and asks for a loan of 900,000 Naira, to buy a mini van for his bakery business. The bank lends him the money. Suddenly the amount of money in the system has almost doubled. There’s the million Naira Mr. Alex has in his bank account. And there’s the 900,000 Naira loan the bank made to Mr. Ade. As you should know, both are asset. Mr. Alex can point to his million-Naira balance on his statement, and Mr. Ade has a bag full of cash. Therefore, both are real. The bank has turned #1,000,000 into #1,900,000, just like that.
The next day, Mr. Ade went to Mr. Eze's Automobile Company and gave him the bag filled with #900,000, in exchange for the keys to a mildly used mini van. Mr. Eze drove straight to the bank to put the cash in his bank account. The bank puts 10 percent (#90,000) aside as a reserve and lends 810,000 Naira to a Mrs Sarah a local provisions seller who needs to buy more products in her shop. She paid the salesman the 810,000 Naira, in exchange for her goods. He also takes it to his bank, which holds 10 percent in reserve, and it keeps going on like that.
See, that 1 million Naira has now more than tripled, in terms of its purchasing power. And yet there’s no new money in the system — it’s still just a million Naira. It’s the banks’ ability to lend that money out, over and over, that creates a ripple effect through the economy and improves everyone’s ability to spend and to grow. Lending and borrowing can be a good thing, in other words. So long as you don’t overdo it.
That means that banks aren’t that bad. Though many bankers do make mistakes. Some bankers cheat, some lie, and some takes foolish risks that threaten the entire global economy. But most banks and bankers work to our mutual benefit, and the network of the country’s banks has become an essential part of our economy, driving money through the system like a heart pumping blood around the body.
If you want to start a lending business, simply take a clue from the banks.