I enjoyed a playful conversation with a young man recently who works at a local bank. He told me that he had been at his current position for the past two years. So, I decided to ask him the following question – “Weren’t you surprised to learn how much gross profit a bank can make with so little risk?” “What do you mean?” he asked. “Banks only make a few percentage points on their investments.” This is when I got a snarky smile on my face and told him to grab a pen and paper so I could show him the math.
“How much (I asked) does your bank currently pay on its long-term certificates of deposit?” He said, “about one percent.” “Okay, let’s look at your auto loans. How much are you charging your best customers for those loans?” “Well, we currently have a deal going for 1.99% for 72-months.” “Can I simply call that two percent, to make the math easier?” I asked. “Sure”, he said. “So, what was the gross profit between the two numbers, if your customer had money in a CD earning 1% and also had an auto loan which charged him two?” “That’s easy”, he laughed. “The bank made only 1%.”
This is where I dug-in. “Grab a simple calculator from your desk”, I ask. “Since the bank earned 2%, but only paid you 1%, take two and divide it into one. What’s the result?” He paused and looked at me strangely – “it’s two of course”. “That’s right, but now we have to take the two and subtract the one, which is what the bank paid us, on our certificate of deposit. What do we have now; two minus one is one, correct?” “That’s right”, he said. Lastly, I said “we need to move the decimal point over two spots to the right to make our number a percentage. So, take the one and add two zeros. That would be 100%”. “What?” He said, “that makes no sense at all”. “Well, let’s check our math backwards to see if it works”, I continued.
“If I take the number one and times it by 100% using your calculator, how much do I have?”. “I have one”, he said. “And isn’t the number one, plus a one hundred percent increase add up to two? Isn’t that the gross profit between one and two percent? I asked.
“And let’s add one more element to our equation. If you missed a payment on your car loan, who gets to repossess it, since the loan had been collateralized with the car?” “The bank”, he said. And then, I continued, “and that’s why other than government buildings, banks have the fanciest buildings in town; and remember”, I said. “This is a 72-month loan. That’s a yearly deal of a potential 100% gross rate of return for six years, for the bank.”