Understanding the banking system is vital to achieving financial independence. It is part of our ongoing financial education and will help free us from the monetary constraints that most of us are under. Today, let’s talk about lending. In particular, how the bank uses your money to lend and how you can do the same thing with much better results, at least for yourself.
How the bank uses our deposits. When we deposit money into our savings account we are paid a measly amount of interest on it. The bank then uses a system called the fractional reserve to lend our money out. The government allows the bank to multiple your money by a certain amount. The amount is different based on the state of the economy. For example, when the economy is running smoothly, the fractional reserve may be set at 20 to 1. This means for every $1 in deposits, the bank can loan out $20. So during these boom times, banks are lending money at high speeds. In fact, before the 2008 bubble burst, they were doing loans called “NINJA” loans. That stood for “no income, no jobs, no assets”.
When times get hard, like during a recession, the fractional reserve may be set to 7 to 1. This is why lending during a recession becomes extremely strict. It is hard to qualify for a loan. I was lucky to get my third home before the 2020 recession started. A month after I closed on my home, banks were asking to see six months’ payments, in cash, for all homes that you owned. This included the home you were buying. So that would have been $30,000 in the bank for me. At the time, I did not have it.
Now, the bank is lending your money out and you are receiving 0.05% on your deposits. Do you think that the bank is lending your money out at 1% interest? Heck no! They are making credit cards and personal loans between 10-25%. They are producing money hand over fist during the boom times. When lending becomes stricter, banks make less money. As an aside, this also plays out on Wall Street. If you have high financial education, you will know when to invest in banks. During recessions, banks make a lot less money and have to keep higher reserves. Their shares on the stock market usually drop pretty low. If you are a long term investor, this is when you want to pick up their stocks. Then when times are good and interest rates are high, bank stocks usually will rise. Homework assignment. Go to yahoo finance and look up my favorite bank, Wells Fargo (WFC). March 1, 2009, during the recession, it was $8.61. January 21, 2018, during the boom time, it was $65.93. Again, this is why financial education can make you rich. Let me know if you want more background on this side topic.
The fractional reserve is how the bank uses your money, multiples it, creates money out of thin air, and lends “air money” out at high-interest rates. So how can you become the bank? Great question. There are two simple ways that you can become a bank; seller financing and hard money lending. For these examples, I will use very low amounts of money, but you can do this for very large sums of money as well.
Seller financing. This is when you own something and instead of the buyer/borrower going to the bank to get a loan, you step in and become the bank. Let’s start with a very simple example that you can do now. I currently own a Samsung Galaxy Tab S4. I could probably sell it for $300 online right now. Not a lot of people have $300. So when I run my ad, I say seller financing available. First, I need to look up the maximum amount of interest I can charge in my state, which is 18% in Florida. Next, I will find a buyer and check their credit. I would find a way to get some kind of collateral. Again, you have to research the best way to do these things. Then comes the contract. I am using the loan calculator (here). Let’s say $50 down and $22/month for a year. The total would come out to $314. An extra $26 may not seem like a lot but it is a 5% return. What if we charged a finance fee, like a bank, and financed the whole amount. $30 finance charge and $27/month. This is $354 or an 18% return. Same math but over 2 years; $30 finance fee and $14/month. This is $366 or a 22% return. You see how the numbers play out.
But Josh, this is unfair to the borrower? But is it though? They do not have to get a hard inquiry. They get to own something that has value, like a computer or laptop. If they went to a bank for a $300 loan, they would be scrutinized. They would get even worst rates than you would give them. And it would be a stain on their credit. If they successfully pay off their loan with you, then it positions them for an even brighter future with transactions between you and them. Maybe next is a computer or a cellphone. How about one of your used cars?
At an even higher level of financial education, you will realize a certain fact. When you created a contract between you and the borrower, you created something called a note. Now let’s take our note of $14/month over 24 months. The total amount of the note is worth $336. You can actually turnaround and sell your note to another investor. Let’s say you sell it for $250. You already received the $30 finance fee, so your total amount is $280.
The highest level is if you were running a “we buy used tablets” business. You could have probably bought the tablet for $100. (remember you make a profit when you buy something, not when you sell it. This means to buy low and sell high). Then you could create a note and sell it for $280 or keep it for $366. Your return on investment is 180% if you sell the note. Your ROI is 266% if you keep the note. Yes, having financial education can put you in a very good position. And believe it or not, you are helping people as well. If you have ever seen a payday lender, you would understand the greed involved. You are helping people out who may need electronics to go to school or get a job. Banks are unforgiving to those without means. Remember that. I have seen it first hand as my wife and I have rented out rooms. There is a whole other world of the have-nots and the banks treat them like second class citizens. You are going to be honest, fair, compassionate, and truthful. It truly is a win/win situation. This is what my Grandpa used to do after he retired.
Hard Money Lending. Hard money lending is very similar to seller financing, but you are giving hard money. This means there is usually no collateral. You can run your business any way that you want. I would recommend starting clients off with small amounts, say $500, and see how they do. Trust me, most people want to stay in your good graces. Especially if you can help them by talking through the financial problems they are having. You may not have any idea of the lack of financial education that is out there but Kris and I have seen it all. By being there and maybe helping them create a simple budget, you are changing lives. You may laugh, but seriously, Kris and I would help some of our roommates figure out their financial issues from the ground up. The same way we would help out our 14-year-old son. They were in their 60s.
Hard money lending is a great way to make a good return on investment and also be a pillar of the community. Again, start with small amounts, get to know your clients, and they will be happy to build up credit with you. You can also make notes out of your hard money loans as well.
Whew, that is a lot of financial education. Let’s put it all together. We know how banks work. We now know when to invest in banking stocks. We understand how we want to sell used products. We can also start a small business buying dirt-cheap electronics and creating notes. Once a person pays back a couple of loans for electronics (collateral) then we can open up hard money lending in small amounts. You don’t need a lot of clients. Maybe 20. Your goal is to always have a rotation of money making you 18% returns. There are lots of people who do this as their main career. However, you need to have money in this sort of business. Being the bank is great but there is a lot more research to be done. I recommend the book “Making Money with Mobile Homes” by Lonnie Scruggs (here) because it is the best book on seller financing I have read. He was getting +70% from doing this with mobile homes. He also talks about financial freedom, before the term was coined. An amazing book and a great place to start. Add “being the bank” to your growing list of ways to become financially independent and start living the life of your dreams.
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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