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The answer lies in what the bank does with your money after you deposit it. You may say that the answer is very simple; they lend the money back out at a higher rate. That answer would be accurate but not complete. In fact, they do not just lend your money out. They effectively lend out up to TEN TIMES your deposit. They have the advantage of LEVERAGE. The reason for this is that the Federal Reserve Bank only requires banks to keep a portion of their loans in reserve; currently 10%. As the bank makes a loan, the loaned money is deposited back into the banking system and a new loan is made. This happens repeatedly until ten times the amount of the original deposit is loaned.
So the bank is very happy to pay the 2% interest on your loan when they will in effect be able to lend out ten times the amount at, say 6%. So on your $1,000 deposit, they pay you $20 and they earn $600. Not a bad return, considering they are using YOUR MONEY. Of course, the more the bank receives in deposits and the more loans it can make, the greater its returns and profit.
Now, there's absolutely nothing wrong or evil with the way banks make money. In fact, it is essential to an expanding economy for the banks to create money in the way they do. What most of us don't realize is that we can use the same principles to expand our own money supply. We simply have to apply these principles to our own investing.
What the bank does is use leverage, i.e., other people's money and velocity, continually moving that money, to continually expand their profit base. Individuals have the same opportunities but many of don't realize it. A simple example of compound interest can illustrate how individuals can use the bank's money to increase their own wealth and cash flow:
Suppose, for example, that an individual has $20,000 to invest. Most investment advisors would tell that individual to put the money in a mutual fund to receive the "high" returns of the stock market. So, let's suppose the investor follows that advice and invests the $20,000 in a mutual fund. Let's say also that the mutual fund does well and returns a 10% return every year for seven years and that all income from the mutual fund is reinvested at the same 10% rate.
At the end of seven years, the investor's $20,000 will have grown to $39,000, or almost double the original investment. Most investment advisors (and most investors) would be very happy with this return. In fact, it would be most unusual to do this well over a seven-year period given the stock market's fluctuations. This result is actually a demonstration of compound interest.
Now let's look at what happens if the investor instead uses leverage to increase the return on that $20,000 investment. For simplicity, let's use real estate for our example. We could use other investment vehicles, such as business activities or stock options, but we are all familiar with how leverage works in real estate.
