The Most Important Rule in Finance

Make no mistake, every bank, lender, or financier uses this rule. It is how they determine the future value of any loan giving today. So why don’t most people know the most important rule in finance or why don’t they teach it in school? Maybe it’s because you may find out how much you actually pay for your dream house and car.

Rule of 72

The Rule of 72 works like this: If an investor with $100,000 to invest and an annual rate of return [interest rate] of 6% – how long would it take to double his money? Using the Rule of 72, this investor would divide 72 by 6 [the annual interest rate] for the answer, that in roughly 12 years that investor would have $200,000.

There is another way of looking at and using this Rule of 72, that is, from a banker’s perspective. When a prospective home buyer applies to a bank for a home mortgage, and if the bank agrees to make the loan, based upon the borrowers ability to repay the loan, [a mistaken notion is the bank extends credit to the borrower. This is false. It is the borrower who has credit, otherwise, the bank would not make the loan] the bank will then, out of thin air, create the loan they provide to the borrower, as a credit to the borrower’s account.

The Brutal Truth

In reality, when making a home loan, the bank is making an investment in the home the buyer is borrowing the $100,000 for. Let’s take the figure we used above – $100,000 dollars. Let’s also use a typical home loan repayment term of 30 years. Let’s also assume the same interest rate we used above – 6%.

Using the Rule of 72, the bank, over the entire term of the loan, 30 years, can expect to get a return on its investment, created out of thin air, of $250,000.

How, you say?

72 / 6 = 12 years (the time it takes to double the initial investment of $100,000).

30 year loan term / 12 = 2.5 x $100,000 = $250,000.

The borrower takes the risks of making the payment, pays all the insurance, pays for the upkeep, pays all the taxes and ends up paying two and one half times what they borrowed for the privilege of being a homeowner, the American Dream, and the bank “earns” $250,000 on the $100,000 it created through financial alchemy. Not bad, eh? Now you know why banks have the biggest buildings in any city.

An investor, instead of taking out a mortgage, would be much wiser to find a way to build their home without a mortgage and pocket much of that $250,000 they would pay to the bankers, who have done nothing more than create the digital money they credited to the borrowers account, based upon the borrower’s good credit.

 

 

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