So what exactly is the “Rule of 72”? Simply stated, you take the number 72 and divide it by your current rate of return, which will tell you how long it will take for the original investment amount to double. For example, say you are your banks “best customer”. Because of this “best customer” status, they grant you a 1% rate of return on your savings account. Let’s illustrate this example to get a better understanding.
You take 72 / by your “best customer” rate at the bank of 1% on your $1,000 investment will equal 72 yrs for your $1,000 to become $2,000.
Wow! I don’t know about you, but I don’t have too many 72 yr cycles in my life!
The rule of 72 leads us to the concept of compounding interest. Compounding interest is the addition of interest to the principal sum of a deposit (or loan) or in other words, interest on interest*. Compound interest was coined “the most powerful force in the world” by none other that Albert Einstein. So why is compound interest so important. Well if you take the same $1,000 deposit and take 72 and divide that by a 4% rate of return, all of a sudden the double time is reduced to 18 yrs. Or how about an 8% percent rate of return, 9 yrs. You getting the point? The better the rate of return, the faster your money will grow. That’s a very important concept to understand.
The rule of 72 can also be used to calculate how compound interest can work against you as well. Against me, how and where does that happen? Any time you borrow money you don’t have, you are being charged interest. That interest on a loan, doubles just like an investment, especially on CREDIT CARDS! Again, let’s look at an example to better illustrate the concept.
You take 72 / by your Credit Card Interest Rate of say 25% on that brand new TV you just purchased for $800. 72 / 25 equals 2.88 yrs. What does that mean? If you only make the minimum payment, usually $25 or so, it will take you 52 months (4 yrs and 4 months) to pay back the $800 purchase price and you will pay $484 in additional interest. WOW!!!
The Rule of 72 is extremely important rule to understand. Moreover, understanding the power of compounding interesting is equally important to grasp. Now the million-dollar question, if the bank will only give me the “best customer” rate of 1% or maybe 1.75% on a CD, where can I get better rates of return as mentioned above of 4,6,8 and even 10%? For that information, please check out my blog on “mutual funds”. If you would like a more personalized look at the possibilities available to you, please email me at louis@louisromero.com.