Have you ever wanted to be able to do compound interest problems in your head? Perhaps not… but it’s a very useful skill to have because it gives you a lightning fast benchmark to determine how good or not so good a potential investment is likely to be.
The rule of 72 is a great math shortcut to estimate the number of years required to double your money at a given annual rate of return. The rule states that you divide the rate, expressed as a percentage, into 72:
Years required to double investment = 72 ÷ compound annual interest rate
This formula is useful for financial estimates and understanding the nature of compound interest. Examples:
- At 6% interest, your money takes 72/6 or 12 years to double.
- To double your money in 10 years, you need an interest rate of 72/10 or 7.2%.
- If your country’s GDP grows at 3% a year, the economy doubles in 72/3 or 24 years.
- If growth increases to 4%, the economy doubles in 18 years. Given the speed at which technology develops, shaving years off your growth time could be very important
You can also use the rule of 72 for expenses like interest or inflation:
- If you pay 18% interest on your credit cards, the amount you owe will double in only 72/18 or 4 years!
- If inflation rates go from 2% to 3%, your money will lose half its value in 24 years instead of 36.
- If college tuition increases at 5% per year (which is faster than inflation), tuition costs will double in 72/5 or about 14.4 years.
Rule 72 can help explain why interest rates are so low in most world economies. Let’s take the U.S. for example; the current deficit is around 18 trillion dollars. At 2% or less for yields on government bonds means the U.S. debt level would take 36 years to double. (72/2 = 36 years) Raising yields back up to the 4% level would only give the government 18 years to deal with the debt problem. (72/4 = 18 years)
The Fed has been overly cautious with its interest rate policy because raising rates not only effects the U.S. government’s ability to pay down debt but other countries who have loans in U.S. dollars. The low interest rate policy has a dual propose. It gives governments more time to fix their debt problem and hopefully it will increase economic growth. More GDP growth equals more tax revenue so that governments can balance their budgets and pay down their existing debt.
In the investment world, low bond yields has forced investors into buying more stocks. The difference between getting an average 8% compound rate of return compared to say 6% over 36 years is substantial. It is why most financial experts advise young people to own more stocks than bonds in their retirement accounts. Another easy way to increase your investment returns is by reducing fees in the mutual funds or ETFs that you buy! Wouldn’t you just love to get a 12% compound rate of return on your investments?
You don’t have to be Einstein to succeed financial. All you need is some basic math skills or just use a good calculator.