What is money?
What is a loan?
How do banks work?
What is interest?
Let's say Andy wants to start a bank. He opens his doors and
promises his customers a safe place to keep their money. Willy walks in with a
thousand dollars to deposit into the bank. Willy hands the money to Andy and
Andy keeps it in a safe. Why would Andy do this? How could Andy possibly make
any money in this type of business?
Let's say Amanda wants to start a lawn cutting business. She
needs to buy a riding lawn mower, and she'll be able to get to work. The problem
is that she doesn't have the money for a lawn mower. She goes to Andy's bank
and asks for a $1000 loan. Andy agrees to give her the loan on two conditions:
1) She'll pay the loan back with 10 percent interest within 1 year. Or, if not,
she'll give Andy the lawn mower.
Amanda uses the $1000 to buy a lawn mower. Business is good
and she makes some money. Within a few months she pays Andy back. She gives him
the $1000 plus the $100 in interest. Andy has now made a hundred dollars. As a
thank you to Willy for doing business with him in the first place, Andy pays
$10 to Willy.
Things now stand like this:
Andy has made $90.00
Willy has $1010 in his account.
Amanda has a lawn mower and a thriving business.
Now, a new customer comes to the bank, Alice. Alice needs
$4000 to start a gym and spa. She wants to buy some workout equipment and put
in a hot tub.
Andy doesn't have $4000, but he gives her the money anyways.
Why would he do that? Why would he give her money he doesn't have.
In the end, Alice pays back everything, plus $400 in
interest. Andy has made some more money, and Alice has great gym and spa up and
running.
Now, imagine that Amanda and Willy and Alice aren't the only customers
of the bank. Andy has hundreds of customers. Some put money in the bank, some
ask for loans. Some people who ask for loans don't pay them back, their
businesses fail. But most loans are paid back, and overall, Andy makes money and the whole thing rolls along.
