Here’s a simple tool to help you appreciate the power of compound interest. Suppose that you have a savings goal and you want to see how fast your savings will grow in various types of investments. You want to measure the difference between options like a bank savings account, a Certificate of Deposit (CD), or a stock market investment. You ask yourself, “How long will it take for my savings to double?’
The rule of 72
The rule of 72 is a neat little trick that makes mental calculations really simple. Just divide 72 by the expected return to find the doubling time. If I had an investment that earned 8% then it would double my money in 72/8 equals 9 years. Simply take the number 72 divide by the expected return and find the doubling time.
How can I use this?
Suppose you are out walking with your friend and they ask for your advice on investing the $1,000 they just got back on their tax refund. They want to save a little cushion for a rainy day. You know that a savings account in a bank will yield you about 0.5%, a bank Certificate of Deposit (CD) would yield about 1%, and over a longer period of time a stock market fund yields about 8%. Painting a mental picture of the savings potential of each option you use the power of 72 rule to quickly calculate the time it would take to grow that $1,000 into $2,000.
With an air of confidence you can project that the savings account at the bank would take 144 years to double (72 divided by 0.5). The CD would double in 72 years (72 divided by 1). If your friend went for a stock market investment, then they could look to double their money in 9 years (72 divided by 8).
What’s the value of this tool?
The power of this tool is that it is easy to use and helps you explain the power of compound interest on investments and it measures it in terms of time. In the previous example with your friend, the explanatory power was in showing the time it would take for the savings account to grow versus the stock market investment. The higher rate of return has an exponential effect on the time to double.
When should I use this tool?
Use the rule of 72 anytime you are comparing investments and want to bring two different rates of return into a meaningful frame. How much better is an 8% return over a 6% return? The 8% doubles in nine years and the 6% will take twelve. If I’m earning a 6% return, but commissions and fees reduce that to 4% then the twelve years gets stretched out to eighteen.
You can also use the rule the other way around to see what size of return you need to achieve your goals. Suppose your friend has ten years before their child goes to college and they would like to see their $1,000 double. Take 72 and divide by 10 years and they would need a 7.2% compounded annual return to reach that goal.
It works both ways
The rule also works for estimating the magnitude of debt. Want to scare yourself away from a credit card purchase? Divide 72 by the rate you are paying on your card. If you are carrying a $1,000 balance on your credit card and paying a 24% interest rate on the balance, use the rule of 72 to show that your debt will double in three years. That makes it a little easier to understand why it is so difficult to pay off those cards.