Investments With the Highest Returns
As we continue on with the topic of interest rates you should check out some of our other posts we’ve compiled such as:
- What Are Banks and How Do They Work?
- 3 Bank Accounts You Probably Didn’t Know About
- The Importance of Compounding Interest
Today’s article dives into the rational thinking of interest rates across different asset classes. You’ll get a bigger picture of how each asset class views borrowing capital and why they do it.
Caution: This is a different style of post so you may find it really basic or already think rationally like these asset classes but for the majority, it should open up new understanding. Enjoy.
How Different Assets View Capital as a Resource
For starters, Lenders want to be compensated for letting you use their assets. Capital is a limited resource. Some people have access to loads of capital while others are very limited in their access to capital.
- This creates a market where humans exchange capital for goods (consumption)
- It creates a market where humans exchange capital to make more money (investment)
And there are many other markets that exist as well but the general overview is that people want to grow their money and they want to spend their money. Consumption and Investment.
Investments are simply loaning your money to another person or source with hopes that your money will grow and come back to you bigger than when it left.
You’ll receive your initial capital back plus interest. Interest takes on many different forms which is what we will be discussing today to sharpen your awareness of each type.
Banks & Interest
In banks, interest goes both ways as we discussed in this article How Bank Interest Rate’s Work
As the depositor, you are lending your money to the bank and they pay you a small interest rate as well as keep your money very safe. It’s a low risk way to invest your money but also comes with a low return on investment (ROI).
On the flip side banks loan out your money to consumers, businesses, auto-buyers, home-buyers, etc. They charged higher interest rates than they are paying their lenders (you) in order to make a profit and to counter the risk of the loans they are making.
Mortgages – these loans are lower risk to banks because the loan is secured/backed by the property. If the person who takes out the loan defaults (misses payment), the bank can foreclose on the property and take back title of the property. Now the bank has the house under its ownership and can sell it to someone else to get the capital back.
Real Estate & Interest
As discussed above, anyone lending in real estate whether it’s a bank or private lender is protected usually by the deed (title of ownership) to a property in the event of a default on the loan.
Lenders in real estate make their money on the interest being charged for the loan. Since real estate is typically an expensive asset, lenders stand to make a lot of money over time if the person taking the loan is responsible and pays the loan back.
Mortgage rates have been historically low due to the U.S Economy melt down in 2008. Currently, you can get a 30 year mortgage for around 4% APR (annual percentage rate). That is if you go through a bank.
If you go through private lenders then the rate will vary.
Private lenders for people who fix and flip property known as hard lenders will typically charge 12% to 15% to borrow their capital for a short term flip.
Private lenders who lend to real estate investors who want to hold on to property long term as a rental property may charge anywhere from 3% to 8% interest. It depends on the location and market you live in.
Why would someone use a more expensive private lender?
The home buyer or investor may not have the credit score or income required by banks to qualify for a loan, forcing them to seek private lending instead which will cost a little above the typical mortgage rate as you can see. Otherwise, investors will go to the bank for the loan at 4%.
See this article to get into the math behind mortgages. It will show you what you’ll spend over the life of a loan as a consumer and on the flip side, what you’ll make if you are the lender.
Stock Market & Interest
First of all, what is the stock market?
Well since we’re talking in terms of interest in this article, the stock market is a market place companies go to in order to raise money for their company.
The term “market” for simple purposes should be thought of as a place two people exchange business.
Since many people exchange business at different rates, you’ll find an average rate of all the business exchanges going on which is called the “market rate.”
So sticking with the current theme, if the company lacks capital then it needs to borrow it.
The company then uses this capital to buy assets such as equipment, employees, other businesses, etc. in order to grow and generate more revenue and bigger profits.
In order to borrow capital, the company issues shares of stock (ownership) to the public for purchase. The consumer gets part ownership of the company and the company gets the consumer’s capital to spend on the business.
Being a part owner of the business now, the lender (Mr. Investor) expects to get paid interest. This interest he expects to be paid comes in two forms commonly:
- Stock Price Appreciation (Increase)
A dividend is interest that the company is pays out to its shareholders and comes from the cash a company has on hand. This cash can be derived from profits if the company has a good year or from cash reserves if the company had a bad year financially.
Dividends are explained thoroughly in this must read series: How Dividend Investing Can Replace Your Job Income
Normally companies do not pay out all of their profits to shareholders. Instead they retain the some or all of the profits (called “retained earnings”) and use it to grow the company. They add this money to their cash reserves where they can spend it on the things needed to grow.
When a company grows or becomes worth more in value, the stock price changes to reflect this increased value. New Investors come into the market place for this company and start paying more for the shares of stock because they want ownership of a growing and successful company.
The original owners who are still holding on to the shares of stock reap benefits finally as they now could sell at a higher price than they paid for, getting their investment back plus a profit.
Interest income in the stock market as with any interest income is taxed by the government since it is considered income. Read all about dividend taxes and capital gains taxes here.
Government Bonds & Interest
Just as companies raise money through the stock exchange to fund business expenses, cities and governments need to raise capital to fund local project expenses.
A city may feel it’s necessary to restore a bridge, build a high way, or other such improvements to make the city more appealing to residents and attract new residents to the area.
In order to raise the millions of dollars in capital it costs them for these projects, they turn to people like us to fund them by purchasing bonds.
Bonds are usually considered safer investments because you are dealing with a city or government and governments basically can’t fail in terms of money. The fed will just print more in times of distaster.
Since bonds are less rick usually, then you’ll be offered a lower interest rate than other investment options to let them borrow your capital.
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