While the idea of compounding interest is great, it’s not always convenient to perform the calculation of:
Total = Principal * (1 + interest rate) ^ # of years of your investment
Although this calculation is relatively simple, I don’t necessarily want to pull out my calculator when thinking about the implications of having my money somewhere that earns 3% vs 7%. For everyday use, I rely heavily on the Rule of 72. This formula is not exact but is the perfect solution for situations where you do not want get hung up in the details and an estimate will do.
The rule of 72 tells you how long it will take to double your money for any investment return. If your investments are earning 9% it will take you 72/9, or 8 years to double your money.
72 = Investment return * # of years it will take you to double your money
The rule of 72 can help you with two basic questions:
1) If my money earns X, how many years will it take to double my money?
# of years = 72/investment return
So if your investment earns 7.2% it will take 10 years to double your money. Whereas if your investment earns 8% it will only take 9 years to double your money.
Used in this manner you can compare return expectations for different investment options.
2) If I want to double my money in Y years, what investment return do I need to earn?
Let’s say you are 50 and have $500,000 in the bank. You want to have $1,000,000 by the time you retire in 15 years at age 65, so what return do you need to receive on your investment?
Required return to double money = 72 / # of years
So in this example it you will need 72/15 or 4.8 percent, to double your money by the time you are 65.
Unfortunately this formula will not tell you if that return expectation is realistic or prudent. However, if your $500,000 is expected to earn only 3% over the next 15 years, you know you either need to save more, wait longer to retire (72/3 = 24 so you will need to wait 9 more years) or adjust your investments to have a higher expected investment return.
As a final note for those of you advanced person finance students out there. This formula assumes interest is compounded annually. Most interest in continuously compounded. However, for back of the envelope calculations this formula works great.
*Photo by ericmcgregor
* I’ve been wanting to add a ‘reader profile’ feature for awhile now. Please contact me (notrustfund <at> gmail <dot> come) if you have any interest in being profiled. Free Money Finance started reader profiles a few months ago and posted one last week that I particularly enjoyed.