Compounding Interest and the Rule of 72

This article will discuss the magic of compounding interest and a quick and easy way to make forecasts based on the interest rate you expect.  Investing or saving money is a way to secure your future.  Your goals should be realistic and achievable.  This discussion will help you decide on your goals and help you develop a timeline for achievement.

Some investment concepts are hard to grasp but compounding interest and its long term benefits shouldn't be one of them.  Most people know how interest works so we'll start there.  If you deposit money into your savings account, you can expect to earn interest on that money while it remains in the bank.  You will note the interest paid on your periodic statements.  That interest is deposited into your account and increases your balance each time it is paid.  If you leave the interest in the account, you will garner even more interest next time because the interest is paid on a greater balance.  This is the basic concept of compounding interest.  Calculating this benefit can be a challenge.  With a very simple rule, called the "Rule of 72," you can estimate just how good the interest rate is and what it will do for you.

The Rule of 72. At a fairly young age, my father taught me the Rule of 72.  It is a rule of thumb that says if you divide 72 by your yearly rate of return or interest, the result will be the roughly the number of years it will take for your money to double.  For an example, let's say you've found a mutual fund that routinely averages 12% return annually.  72 divided by 12 is 6 so...whatever money you have invested now should double in 6 years if the fund continues at the 12% pace.  If you're conservatively investing in Certificates of Deposit (CDs), you may be lucky enough to find a 6% annual return which would mean it would take 12 years to double your money.

Applying the Rule of 72.   This rule can be used to forecast returns or set goals for the future.  For instance, let's say you have $20,000 today and you want to know how long until you'll be a millionaire.  First, pick an interest rate (let's use 12%), determine the time to double (6 years as in the previous example), and do a little doubling math.  After 6 years, you'll have $40K, 12 years-$80K, 18 years-$160K, 24 years-$320K, 30 years-$640K, and at 36 years-1.28 million dollars.  So...somewhere around 33 years from now, you'd become a millionaire.

Compounding interest is a concept that requires disciplined saving, careful investment, and the knowledge that reinvested returns only add to the potential for greater wealth.  The Rule of 72 is a simple rule of thumb that can tell you roughly when to expect the investment you have now to double.


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