Rule of 72

Rule of 72

We are going to discuss the following:

  • Simple Interest & Compound Interest
  • What is the Rule of 72? How much time it takes to double your money?
  • Rule of 72 formula
  • Understanding the Rule of 72
  • Rule of 72 Calculator

Simple Interest & Compound Interest

The interest rate credited on an investment or charged against a loan can be : simple or compound. Simple interest is calculated by multiplying the interest rate by the principal amount. It is used to calculate interest on investments where the interest earned is not added back to the principal.

Whereas, in case of compound interest, the interest is calculated on the initial principal and also on the accumulated interest. I is like – “interest on interest”. This way, money can grow at a much faster rate compared to simple interest.

In layman terms, since the interest portion of the money gets accumulated in case of compound interest, it raises the principal value with each passing month/year and generates exponential returns in the long term. By not withdrawing the interest every month, the investor is increasing the principal value which helps him earn more interest.

What is the Rule of 72?

In the financial industry, the rule of 72 is a way to calculate how much time it will require to double an investment. It is a quick way to mentally calculate the number of years it will take to double the money.

Rule of 72 formula

                                              72
Years to Double =  ——————–
                                     Interest Rate

Interest Rate = Rate of return (ROR) on an investment​

Understanding the Rule of 72

The Rule of 72 is applicable to money/investments, inflation, fees, expenses, or any entity that grows like population or the GDP.

Rule of 72 helps to understand the effect of Compound Interest.

If the rate of return is between 6% to 10%, this simplified formula work really well. At higher rates, the approximations become less accurate.

The accurate formula to calculate the exact time to double the money is-

                ln(2)
td = ———————
                        rr
       ln ( 1 + ——- )
                      100
where:
td = Time to double
ln = Natural log function
rr = rate of return per year

Lets take a simple example to understand this concept:

* If you have $10K at the age of 29 and if you get 2% interest on it every year, your $10K will double after 72/2 = 36 years.

* What if you get 4% every year, now the money will double every 72/4 = 18 years. You will have 2 opportunities to double your money.

* What if you get 8% every year, now the money will double every 72/8 = 9 years. You will now have 4 opportunities to double your money. Your $10K will now become $160K.

* Now, what if you get 12% every year? The money will double every 72/12 = 6 years. Remember that you did not add a penny on top of $10K. Your $10K would now be almost $650K!

This is the magic of power of growth by compound interest.

Albert Einstein called compound interest the eighth wonder of the world. But it doesn’t just apply to finance.

Warren Buffet has a very interesting take on Compound Interest. He says – Those who understand it, EARN it and those who don’t, PAY for it.

A classic example to understand this is how a lot of people MAX out their credit
cards to maintain their lifestyle and then only pay the interest on them.

The interest rates on these credit cards are extremely high – 15-30%. National average interest rate for credit cards is over 16%.
         Source: https://www.bankrate.com/banking/savings/rates

Compared to that, national average interest rate for savings accounts is .10%.          Source: https://www.creditcards.com/credit-card-news/rate-report

This means that the banks are doubling they money every 3-4 years!

Once people understand this, they will never want to have outstanding credit card debt!

Rule of 72 Calculator

Calculate to see if you will be able to retire a millionaire?

Rule of 72 Calculator

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