Use the Rule of 72 to Understand Compound Interest
Most people generally understand the concept of compound interest, knowing that over time, interest earned will begin to snowball and accumulate more rapidly. Even though it is a relatively simple concept, visualizing how it works can be more difficult.
I think Albert Einstein said it best:
Compound interest is the greatest mathematical discovery of all time.
So, what is the Rule of 72 and what does it have to do with compound interest? The rule simply states that if you divide 72 by the interest rate, it will tell you how long it takes for your money to double. For example, assume you earn a 6% rate of return on your money. To find out how long it takes for your initial amount of money to double, just do the simple calculation: 72 / 6 percent = 12 years.
It doesn’t matter if you have a starting balance of $500 or $50,000, if you earned a real rate of return of 6% each year, you will double your money after 12 years.
Table of Returns
This table should highlight the importance of squeezing the most out of your money. If you notice, your checking or savings account at the bank earning 1%, by keeping your money there and you’ll need 72 years to double it. But, if you can manage to even get 3% on that money, you can shave 48 years from that goal. Even a modest 7% return will allow you to double your money in just over 10 years.
Even more impressive is when you consider the higher rates of return. For instance, if your investments are in the market during 5 good years and you can realize around a 14% return, you will double your money in that same period.
The Big Picture
For most people, the number of years to double your money seems like a long time. Even at a modest 7% return, that’s just over 10 years. Well, it may seem like a long time, but this is where you have to really take into account the power of compounding over the long term.
Let’s use an example of a 25 year old who has $10,000 saved up in a retirement account. For simplicity, let’s say that the account is earning 7.2% per year, so according to the Rule of 72, the money will double every 10 years.
As you can see, it starts out kind of slow. By age 35, it might not feel like much to have $20,000 saved up. But as the decades pass, the numbers accelerate in value as they double, to a point where by retirement, a measly $10,000 has turned into over $150,000. Money begets more money over time.
Also keep in mind, this is simply using a single lump-sum with no additional money being saved. When you consider that most people would be continuously adding money to this investment, the rate of compounding goes up significantly.
Keep in mind that the Rule of 72 is just a guideline. Clearly, in the real world you’ll almost never have a constant interest rate unless your investment is in a long-term fixed income vehicle. In addition, you will want to consider the impact of taxes and inflation on your results. This rule is simply a tool to help illustrate the impact that time and rate of return has on your money.
Remember, time can be either your greatest asset, or your worst enemy. The sooner you start, even if by just a small amount, it will provide more time for your money to compound. On the other hand, every passing week, month, or year is time that you can never get back. It is up to you to decide if you want time to be on your side or working against you.