Saturday, April 3, 2021

Compound Interest: The Rule of 72

Compounding is the way your money grows on its own, and it's the main reason to start saving as soon as you possibly can. There are two basic methods of calculating interest:

Simple Interest

Simple interest accumulates only on your initial investment. For example, if you have $1000 that earns 5% simple interest annually, every year your account would grow by $50. [5% x 1000 = $50]

Compounding Interest (CI)

With CI, you earn interest on your investment plus the interest it's already earned. For example, if you have $1000 that earns 5% interest compounded annually, you'd earn $50 [5% x 1000] the first year. The second year, you'd earn interest on your new balance of $1050, so your interest for the year would come to $52.50 ($1050 x 5%). 

The Rule of 72 

The rule of 72 is a nifty mathematical computation you can use to estimate how long it will take a certain sum of money to double at a certain interest rate (assuming it is CI). 

Calculating Years to Double Investment

To calculate how quickly your investment will double, divide 72 by the interest rate or expected rate of return (for earnings other than interest, such as dividends or capital gains). The result is the number of years it will take your money to double, assuming you reinvest your earnings. Given a situation:

Compound Interest: 8%
The rule of 72: 72 / 8 = 9 years

This means it will take approximately nine years for your initial investment to double. 

Calculating Rate of Return to Double Investment

You can also use the rule of 72 to estimate what rate of return you'd need to earn for your money to double in a certain number of years. Given a situation:

Expected years to double investment: 10 years
The rule of 72: 72 / 10 = 7.2 %

This means you need to earn 7.2 % annually for your money to double in 10 years.

Calculating Years for Debt to be Double

You can use the rule of 72 to see how long it will take your credit card or other debt to double too. Given a situation:

Credit Card Balance: $5000
Credit Card Interest: 10%
The rule of 72: 72/10 = 7.2 years

It means that your credit card debt will be double ($10000) in 7.2 years. 

p/s: In conclusion, double your saving, not your debt. 😏

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