How do you know when your investments are expected to double, when your credit card debt will be paid off or how interest is charged to your mortgage?
Well, this little tip is the greatest financial tool, time saver and money motivator you’ll ever learn; and it will leave your friends and family astonished when you can quickly work out complex financial equations quickly in front of them!
I’m sure you have all heard about ‘compound Interest’, right? Yes, it is a great term that if used correctly can help you build wealth faster, or it might be the devil in the detail on your debt. But exactly how is calculated and what is a quick way to work it out?
Well that’s where ‘The Rule of 72’ comes into it – the nature of compound interest – is a brilliant way for you to roughly estimate how your investment (any asset or debt) will grow over time.
Simply divide the number 72 by your investment’s expected rate of return to find out how many approximate years it will take for your investment to double in value. For instance, if you invest $5000 today at 8 per cent, your investment will double every nine years (72/8 = 9).
The Rule of 72 is a great way to quickly estimate the effect of any growth rate, from quick financial calculations to population estimates. Here’s the magic formula:
Years to double = 72/interest rate
This formula is useful for financial estimates and understanding the nature of compound interest. The Rule of 72 is only a rough guide but provides great insight into many areas of normally complex equations;
- At 6% interest, your money takes 12 years to double (72/6 = 12).
- Then, to double your money in 10 years, you need an interest rate of 72/10 or 7.2 per cent.
- If your country’s GDP grows at 3% a year, the economy doubles in 24 years (72/3 = 24).
- If your growth slips to 2%, it will double in 36 years. If growth increases to 4%, the economy doubles in 18 years. Given the speed at which technology advances, it is important to consider how quickly an economy is growing too.
The rule of 72 shows why even a small 1% difference in inflation or GDP has a huge effect in forecasting models and applies to anything that grows, including population.
Can you see why a population growth rate of 3% vs. 2% could be a huge problem for planning? Instead of needing to double your capacity in 36 years, you only have 24. Twelve years were shaved off your schedule with one percentage point – amazing stuff to know and understand!
Practical examples of the Rule of 72 in action;
John Smith an Investor, needs to double his money in five years to reach his financial goals. What rate of return must he earn to do this successfully? (Answer; John would take 72 divided by 5; and the answer 14.4% ie. so 14.4% is the amount he will need to earn ‘after-tax’ to successfully reach his goal)
Sarah Marr another Investor, is earning a 9 per cent after-tax return on her investments. How long will it take Sarah to double her money? (Answer; to calculate the number of years necessary to double her money using the Rule of 72, Sarah would divide 72 by 9; the answer, 8, is the number of years it will take for her investment to double after taxes).
You can also use The Rule of 72 for expenses like interest; alarmingly, if you pay a rate of 15% interest on your credit cards, the amount you owe will double in only (72/15) 4.8 years!
Remember this isn’t an exact science, it is a quick ‘rule of thumb’ that allows you to make a judgement so if you were to invest $100 at an interest rate of 9% per annum, the rule of 72 says (72/9) it will take 8 years for the investment to be worth $200 (double). If you did the calculation exactly, it would work out at 8.0432 years.
It is the magic of compounding interest and time in any market (shares or property). Interestingly, if you were to invest roughly $1000 in Australian shares 50 years ago, it would now be worth $150,000, earning the same as the All Ordinaries Index with returns being reinvested. If you took into account inflation, that $1000 would really only be about $32,000 after 50 years, so the additional $118,000 is the effect from compound interest and capital growth.
So now you know about The Rule of 72 as an easy, quick tool to help you plan and reach your financial goals whether it be paying down that credit card sooner or working out when your investments will double. The most important thing to remember however that the best rule to achieving anything is to always start NOW!