Thanks to compound interest, our money often does a good chunk of the growing for us. The rule of 72 tells us how fast we can expect this growth to come.
Whether you're saving for retirement, a down payment for a house, or other goals, it's important to know what to expect for your financial future. That's what makes the rule of 72 so important.
How—and why—to calculate the rule of 72
The rule of 72: Divide the interest you are receiving into 72 and thats how long it will take for your money to double. Example 12% return on your money will double every 6 years. Same thing with credit cards a 25% interest your balance will double every 3 years.— ℐ𝓇𝓌𝒾𝓃 𝒵𝒶𝓅𝒶𝓉𝒶 (@HeadxShot760) December 2, 2020
The formula for the rule of 72 is this:
72 / interest rate = years it would take for your money to double
You can perform this formula for each account in which you hold your savings. This includes high-yield savings accounts, money market accounts, and even mutual funds.
Using the result from the equation, you can figure out how many times your money will double over the course of your lifetime.
Why is this important?
Some accounts provide higher interest yields than others. Those on the low end of the spectrum will take hundreds of years to double, simply because the interest you receive is so low. For example, the federal average for standard savings accounts is just 0.04 percent as of December 2020. If you perform the rule of 72 on this interest rate, you learn that it would take you 1,800 years just to double your money.
On the contrary, high-yield savings accounts with a 1 percent APY will take your money 72 years to double. Up the interest to 3 percent and you'll see your money double in 24 years.
For accounts with higher returns, like index and mutual funds, you may earn interest closer to 10 percent. In this instance, your money will double every 7.2 years without you lifting a finger.
Based on data from 1926–2018, the S&P 500 offers an average annualized return of 10–11 percent. Say you earn 11 percent. Apply the rule of 72 to that number and you'll see your money double every 6.45 years.
Keep in mind this is all without adding anything to the pot. This is compound interest doing its work. If you consistently invest small amounts of money over time, you're speeding up the process even further.
The rule of 72 helps you understand compound interest
Life starts when you know Rule of 72!— Wall Street Sizing Up (@WallStSizingUp) December 2, 2020
Generating wealth on our own is difficult. At some point, we need our money to do some of the lifting. That's what makes allocation and investing so important.
If you leave a shoebox worth of cash untouched under your bed for 20 years, there's a zero percent chance that money will grow. However, if you allocate those funds to a high-yield savings account or investment fund, you're allowing your own money to take some of the burden off your shoulders.
Compound interest is defined as interest that's calculated atop the initial principal. This includes all of the accumulated interest from previous periods, too. Basically, compound interest helps you reach your goals quicker and easier, without so much sweat off your back.
The rule of 72 also applies to money you owe
It's not just interest yield that the rule of 72 works on. It's interest rates, too. If you owe money on a credit card with 25 percent interest and you don't pay anything off, the amount you owe will double every 2.88 years.
Take your time horizon into consideration with the rule of 72
Biggest risk & Biggest fund manager in the process of investment is “Time” let rule of 72 decide the same. Assuming risk free rate of return is 6% and money is getting doubled in 12 years. Increase your time horizon by same % you want your return to increase above risk free rate— Sachin Taksali (@SachinTaksali) November 30, 2020
If you have 40 years until retirement, you may be fine sticking with a lower interest yield. However, the less time you have until your goal, the more interest you require. Consider your specific goal, how many years you have until it, and what interest rate you require to satisfy your end game.