If you learned some basic multiplication tables in school,
then you have the foundation to understand one of the most important rules in
regards to how money works – the Rule of 72. I first heard about the Rule of 72
in a Money Management class that I took back in high school (thanks to Mr. F), and it blew my
mind. In the most basic form, if you take the number 72 and divide it by a rate
of return, you will have a rough idea of how many periods (usually years) it
will take for your money to double. That’s it. That’s all you need to know.
Pretty simple, right? Let’s take a look at how it works in real terms:
As an example, let’s say that you were offered an investment that claimed to pay you 6% annual interest. How do you know if it’s good or not? Well, take 72/6 and it will tell you that your money will double in roughly 12 years. If you have $1,000 that you invest in 2013 and don’t touch it until 2025, you will then have $2,000. What’s even better is if you don’t touch it for another 12 years, you will have $4,000 in the year 2037. Sounds pretty good, right?
What if you were only able to find an investment that paid 3% annual interest? If you run the math, that would take 24 years for you to double your money (72/3 = 24). See what happens again with that $1,000:
3% Annual Interest
2037: $2,000 (24 years later)
2061: $4,000 (48 years later)
So the difference between 6% interest and 3% interest may not seem like that big of a deal, but it’s the difference between having $4,000 in 2037 (at 6%) and $2,000 in 2037 (at 3%). Ready to really have your mind blown?
What if we went 3% higher and you could get 9%? That means your money would double every 8 years, as you can see from the chart below:
9% Annual Interest
2021: $2,000 (8 years later)
2029: $4,000 (16 years later)
2037: $8,000 (24 years later)
So the question to ask is, do you think that the difference between 3%, 6%, and 9% rate of return is significant? If it is a big deal to have $2,000, $4,000 or $8,000 in the year 2037, then you bet it is!
Important Tips for Further Application:
- Understand that investments come with risk. Higher rates of return usually come with higher volatility or risk. Just because someone is offering you 18% interest on a “sure thing” doesn’t mean that person actually could pay you back. There is a risk/reward balance. Chances they could be offering you 18% interest because they didn’t have any takers at only 12%. Plus, they have to earn more than 18% back on the money you gave them just to be able to pay you back. So look at the risk/reward and only move forward if you’re comfortable knowing the situation.
- Remember that these numbers also apply for debt. If someone is offering you a rate on your school loans, cars loans, mortgage, etc, take a few moments to plug that number into the rule of 72 and see if you can afford that over time. 1% difference on a mortgage can make a big difference if you are taking 30 years to pay it back.
- Not to be the bearer of bad news, but there is also a dirty little player in this game called inflation. As you know, the cost of things go up over time. On average, 3-3.5% is a rough number of what inflation has consistently averaged in the past. The reality is that you need your money to average 3-3.5% just to keep up with inflation. I don’t want to end the article on that downer, so I’ll state that while many things do inflate, the cost of other things does drop over time. Think about the cost of TVs and how much cheaper they are now than just a few years ago. Or DVD players? There, we can end on that positive note! Happy trails as you use the Rule of 72 in the future.