I am a financial professional, and I love to share the simple truths about finance that can change people's lives when applied.
What Is the Rule of 72?
The rule of 72 is a simple equation often attributed to Einstein (although in reality it was around before he was) that helps you to calculate a close estimate for how long it will take for something to double.
This rule can be applied to population, and an abundance of other scenarios, but right now we are going to focus on money. After all, who doesn't want to double their money?
If you dream of being a multimillionaire someday, you really want to get a firm understanding of this simple equation to measure the effects of compound interest.
After all, Einstein was quoted as saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.”
Most people would prefer to be on the understanding and earning side of this quote than the not understanding and paying side, but there are a huge amount of people that are allowing their debts to double by paying interest rather than creating wealth by earning interest.
This rule can also help you to calculate the amount of time it will take for your buying power to diminish by half due to inflation, so it is good to understand all of its functions.
After all, you might be disappointed when you follow the rule well enough to get your first million and realize that it's now only worth half of what you thought it was going to be worth. We'll go into more detail about that later though.
Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.
— Albert Einstein
The Math Behind the 8th Wonder of the World
By now you are probably more than ready to see this equation and get a few examples of how it works. The equation looks like this:
72 / Percent Rate of Return = Doubling Time
Now for a few practical examples of how this equation can give you an estimate of how quickly your money will grow. Let's say you have $1,000 sitting in a bank account where it is earning about 1% interest. That's actually a pretty high estimate for a bank account, but we'll be optimistic.
72 / 1 (your rate of return) = 72
This means that your $1,000 will double to $2,000 in approximately 72 years.
Now let's pretend that rather than keeping that $1,000 in the bank, you decided to invest it in a conservative investment that is averaging a modest 4% in returns.
72 / 4 (your rate of return) = 18
This means that your $1,000 will double to $2,000 in approximately 18 years.
All right, now that you have the idea, let's have a little bit more fun. Let's say you invest your $1,000 using an investment vehicle that is averaging around 8% in returns.
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72 / 8 = 9
This means that your $1,000 will double to $2,000 in approximately nine years.
Do you see how this can get really exciting once you get the hang of it. I think that most people would agree that they would rather double their money in nine years than waiting a whole 72 years for their money to double.
In this world, most people don't have the time to wait 72 years for their money to double in a bank account, especially if they want to have sufficient funds to live comfortably in their retirement.
Estimated Earnings On Investments Using the Rule of 72
|Original Cash Value||Rate of Return||Years it Takes to Double||Times Doubled in 36 Years||Cash Value In 36 years|
How Does the Rule of 72 Apply to Debt?
While it is pretty exciting looking at how quickly your money can double with a good rate of return in a solid investment vehicle, it's also important to look at the flip side of the rule of 72.
We live in a world where a lot of people owe huge debts. Think about the credit cards in your wallet. How much money do you owe on each one? Can you remember what the interest rates for your credit cards are?
This is the time when we talk about Einstein's point that those who don't understand compound interest pay it rather than earning it.
Just like you can figure out how long the amount of money you are investing will take to double using the law of 72, you can also figure out how long it will take for your debt to double using the same equation.
72 / Percent Interest Rate Owed = Time for Debt to Double
The average credit card interest rate in February of 2015 was somewhere between 13% and 15% depending on whether you were talking about fixed rates or variable rates.
Unfortunately those rates are much higher than the rate of return that most people are getting on their investments.
This just shows again how little the average person knows about compound interest and the effects it can have over time.
So, let's say that you are lucky and your credit card only has a 12% interest rate and you owe $1,000. Unfortunately, you aren't lucky enough to feel like you can make your credit card payments, so your debt just keeps adding up and adding up.
72 / 12 (your credit card's interest rate) = 6
That means that in approximately six years, you would owe $2,000 instead of $1,000.
Even making minimum payments on credit cards, you end up paying much more money than you initially owed.
As you can see, your creditors don't really mind that much if you want to rack up your bills and then take your sweet time to pay them. The more money you owe initially, and the less you pay back, the more money your creditor is going to make down the road.
If you've had any experience with this in the past or even presently, you probably understand that the power of compound interest can be extremely overwhelming when it is working against you.
How Does the Rule of 72 Apply to Inflation?
This aspect of the rule of 72 isn't very fun to discuss, but it is important to understand. When you divide 72 by the rate of inflation, it will tell you how long it will take for your money to lose half of its value.
72 / Rate of Inflation = Time for Money to Lose Half its Value
It's important to be aware of this, because it turns out that a million dollars isn't going to be worth as much down the road as it is now.
Just think about how much the price of milk has gone up in your lifetime, and it is easy to see that a dollar doesn't go as far as it used to.
Let's say that the inflation rate is around 4% and then see how long it would take for your money to lose half of its value.
72 / 4 (Hypothetical Rate of Inflation) = 18
That means that if the rate of inflation is 4%, in 18 years your money will lose half of its value.
You can look up inflation rates here, although it is important to note that the way the United States calculates inflation makes the rates appear a bit lower than they actually are.
There is some tricky calculating in the United States to help us feel more at ease about inflation rates, so you kind of have to take the official inflation rates as a grain of salt.
It's important to keep the inflation end up the rule of 72 in mind, because it turns out that people who think they need a million dollars to retire may find out that their million dollars is worth a small fraction of what they thought it would be worth when they started investing.
That means that as you plan for retirement, it's probably wise to shoot for having 2-4 times more money than it would take for you to retire comfortably today.
Start Accumulating Wealth by Making Compound Interest Work for You
Now that you understand how the Rule of 72 works, you have the knowledge to make compound interest work for you so that you can accumulate an abundance of wealth by following these tips:
- If you are currently in debt, vigilantly work at paying your debt off as soon as possible.
- Find a financial adviser with a good track record that can help you choose suitable investments that will help you to achieve your wealth accumulation goals.
- Remember that a million dollars in 30 years won't be worth as much as a million dollars now and plan accordingly.
You can use the Rule of 72 to:
- Calculate time needed for an investment to double
- Calculate the time it will take for your debt to double
- Calculate the effect of inflation in reducing the buying power of your dollar
- Begin accumulating wealth
Will You Have Enough Money When You Retire?
How much do you need? Check out this article to find out how much money you really need for retirement.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
Stephanie Launiu from Hawai'i on April 21, 2015:
Wow this is an awesome hub. I had heard of the Rule of 72 with interest on savings, but never applied it to debt doubling or inflation. Pretty amazing information. Voted up, useful, awesome, interesting. Also tweeted out. Aloha, Stephanie