“Building Wealth with Ownership Investments”), the other major types of
investments include those in which you lend your money. Suppose that,
like most people, you keep some money in your local bank — most likely in
a checking account, but perhaps also in a savings account or certificate of
deposit (CD). No matter what type of bank account you place your money in,
you’re lending your money to the bank.
How long and under what conditions you lend money to your bank depends
on the specific bank and the account that you use. With a CD, you commit
to lend your money to the bank for a specific length of time — perhaps six
months or even a year. In return, the bank probably pays you a higher rate of
interest than if you put your money in a bank account offering you immediate
access to the money. (You may demand termination of the CD early; however,
you’ll be penalized.)
The double whammy of inflation and taxes
Bank accounts and bonds that pay a decent
return are reassuring to many investors. Earning
a small amount of interest sure beats losing
some or all of your money in a risky investment.
The problem is that money in a savings account,
for example, that pays 3 percent isn’t actually
yielding you 3 percent. It’s not that the bank is
lying — it’s just that your investment bucket
contains some not-so-obvious holes.
The first hole is taxes. When you earn interest,
you must pay taxes on it (unless you invest the
money in a retirement account, in which case
you generally pay the taxes later when you
withdraw the money). If you’re a moderateincome earner, you end up losing about a third
of your interest to taxes. Your 3 percent return
is now down to 2 percent.
But the second hole in your investment bucket
can be even bigger than taxes: inflation.
Although a few products become cheaper over
time (computers, for example), most goods
and services increase in price. Inflation in the
United States has been running about 3 percent per year. Inflation depresses the purchasing power of your investments’ returns. If you
subtract the 3 percent “cost” of inflation from
the remaining 2 percent after payment of taxes,
I’m sorry to say that you lost 1 percent on your
investment.
To recap: For every dollar you invested in the
bank a year ago, despite the fact that the bank
paid you your 3 pennies of interest, you’re left
with only 99 cents in real purchasing power for
every dollar you had a year ago. In other words,
thanks to the inflation and tax holes in your
investment bucket, you can buy less with your
money now than you could have a year ago,
even though you’ve invested your money for
a year.
As I discuss, you can also invest your money in
bonds, which are another type of lending investment. When you purchase
a bond that has been issued by the government or a company, you agree to
lend your money for a predetermined period of time and receive a particular
rate of interest. A bond may pay you 6 percent interest over the next five
years, for example.
An investor’s return from lending investments is typically limited to the
original investment plus interest payments. If you lend your money to Apple
through one of its bonds that matures in, say, ten years, and Apple triples
in size over the next decade, you won’t share in its growth. Apple’s stockholders and employees reap the rewards of the company’s success, but as a
bondholder, you don’t (you simply get interest and the face value of the bond
back at maturity).
Many people keep too much of their money in lending investments, thus allowing others to reap the rewards of economic growth. Although lending investments appear safer because you know in advance what return you’ll receive,
they aren’t that safe. The long-term risk of these seemingly safe money investments is that your money will grow too slowly to enable you to accomplish
your personal financial goals. In the worst cases, the company or other institution to which you’re lending money can go under and stiff you for your loan.
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