One Rule to Rule Them All: The Rule of 72
Want your money to work for you while you sleep? Sounds great- but how do you make it happen? Once you have some money put away in savings, watching it grow can be thrilling. Month after month watching that balance grow while you’re kicking back is the way to let your money work for you. Plant seeds now that will grow into a strong and ripe financial garden that will sustain you with Financial Independence. Compound Interest is the way your money will constantly build on itself and grow exponentially over time. The Rule of 72 helps determine how many years that growth will take.
What is Compound Interest?
Compound Interest is a force as strong as gravity. Given enough time, it will double your money many times over. Interest plus time is a sure path to becoming truly wealthy. A concept you may have learned about back in grade school, Compound Interest needs to be your new best friend. Compound interest happens when your investment creates a return, and the return is added to the original investment. The original investment thus becomes larger. The larger investment now creates a larger return that is added to the original investment once again. Rinse and replay. As you can see, as this process repeats itself the original investment and the returns both grow. Over time, this exponential growth that occurs is magnificent. The longer your cash has to grow, the harder it will work generating returns. Different types of investments generate returns in different ways- but as long as the returns are added to the original investment, compound interest will work its magic.
How does Compound Interest work?
Other than time- Return on Investment (ROI), also known as interest rate or rate of return, is the other piece to this puzzle. ROI is expressed in a percentage per year. It indicates how much interest your original investment will make over a year. Many people see this interest as APR or APY at banks with savings accounts. When you invest in anything that will bring you returns, the amount is expressed in a percentage. If the percentage stays the same and the principal balance grows, the dollar amount of the returns grow.
For instance- if you invest $1000 and it makes $80 in interest over a year, the ROI would be 8%. The next year you have $1080. Your yearly return at 8% would then be $86.40. Adding the interest accrued to the principal balance will cause this magical compounding to happen. Each time your investment makes money, the amount it makes will increase. That is if the ROI stays the same of course.
Understanding ROI is important because it is one of the two numbers necessary to calculate how much money your money will make over time. Maximizing ROI is something that even financial experts debate over at length. The S&P 500 since 1926 has averaged a 10% return. This is the average return of the entire life of the S&P 500. Some individual years are much less, some are much more.
What is the Rule of 72?
Enter The Rule of 72- it helps with estimating the speed at which your investment will increase in value. It will tell you, based on your ROI, how many years it will take money invested to DOUBLE. This is going to be sweet. Here’s how you figure it out: Divide 72 by your ROI. The result is how many years it will take for your investment to double. Let’s use the example of the $1000 investment mentioned earlier. You’re receiving an 8% return on your investment. According to the Rule of 72, you will have $2000 in 9 years. BOOM. Money doubled- just like that. The Rule of 72 is used to estimate future value of your investments long term. Below is a chart that shows the power of this compounding in action.
This is with NO money added in the duration of the 39 years! Compound Interest simply takes over. This person started with $1,000 on year one and it grew to over $20,000. That’s a 20x return on your money over that time! Granted, 39 years is a long time. Not everybody has the amount of time to allow 39 years to grow their money. Just think if you started investing early and often- how huge your final amount could be using Compound Interest over time. The moral of the story here is… START EARLY!
How to take advantage of the Rule of 72
How can you speed this process up? One way is to increase your ROI. Generally, higher risk investments have greater returns. This is not always the case, as you could end up losing money while taking on higher risk. So trying to increase your ROI by taking on more risk may end up achieving the opposite effect. The other way to speed up the process is to be continually adding to the principal balance of your investment. This will accelerate not only the balance of the account but also the amount of future returns you can make.
Where is your money invested? Savings account? Retirement account? Real Estate? The average savings account yields just 0.06% yearly interest! Using the Rule of 72, it would take 1,200 years for your investment to double. I don’t think I have the time to wait on that. Like I previously mentioned, the more risk you take with your investment the more return you can hope to make. Investing in high quality index funds that track benchmarks such as the S&P 500 are a safe and reliable way to go. If the market continues to do what it has done since 1926, you can hope to double your money every 7.2 years. Keep in mind the stock market is not the only way to take advantage of the Rule of 72.
Any investment that provides returns that are added to your principal investment use the principles of the Rule of 72. Looking for a higher ROI on your savings account? iFireFinance recommends the NEW Personal Capital Savings Account that offers 2.30% yearly ROI on your money. That is almost 40 times as much interest as the normal savings account at your bank. At that rate, it will still take 31 years for your investment to double- but it sure beats 1200 years.
About the Author
Contact Bruce Breedlove at iFireFinance for questions or comments about this article! He is our Finance Personality and Registered Nurse at Mayo Clinic in Jacksonville, Florida. Bruce offers Personal Finance Coaching services for clients anywhere in the country! Check him out on Instagram at @iFireFinance. Contact him for a FREE consultation regarding a personalized financial plan!
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