The Rule of 72

By ch1c0nta@ctus 07.21.2010 blog

So, you’ve decided to make your money work for you by saving and earning compound interest. That’s great! But how much will you have in the future? Will it be the amount you have in mind? Will it be enough to help with college expenses, for example, or to buy a car? There’s a simple way to find the answer. Read on and find out.

First, what exactly is compound interest anyway? This is the good part. It’s the percentage a bank pays you on the money you deposit into your account and on the interest the bank has already paid you, provided you keep it in the account. Need an example? Let’s say you save money from babysitting or mowing the neighbor’s lawn, along with birthday and holiday gifts, and it all totals $1,000. You decide to deposit this money into an account earning 6% interest. At the end of one year, you’ll have $1,060. That’s an extra $60 for doing nothing. It gets better.

After two years, you’ll have $1,123.60, because the bank pays you another 6% on the original $1,000 you deposited and on the $60 in interest that the bank previously added to your account. Year three? You guessed it: The bank pays yet another 6% on your original $1,000 and on the $123.60 in interest you’ve earned to date. And on and on it goes. Your money earns money as long as it remains in the account. The more you accumulate, the more interest you earn. It takes patience though, because compound interest has the greatest benefit over time.

That sounds like a good deal, but, you might ask, how do I know how much cash I’ll have in the future?

You don’t have to be a math wizard to see how your money can grow. We know a simple little trick called The Rule of 72. Financial types have used it for centuries. Seriously – it’s on Wikipedia. The Rule of 72 is a shorthand way to figure out how many years it will take for compounding to double your money at a given interest rate. Simply divide 72 by the interest rate you’re earning.

Let’s go back to our first example. You have $1,000 and you want to know how long it will take to double your money. If you earn 6% interest each year on your account, you divide 72 by 6:

72 ÷ 6 (representing 6% interest) = 12 (years to double your money)

At the end of 12 years, you will have just over $2,000 in your account.

Remember, this illustration only focuses on the impact of compounding on your initial deposit of $1,000 and does not take into account any additional deposits you might make over time. If you were to deposit another $100 each year to your account, it would take only 6 years for you to have $2,000.

OK, now you give it a try. If you want your savings to double in 9 years, what interest rate do you need to make this happen? Answer: 8%. Why? 72 ÷ 8 = 9.

Here’s something a little more complicated: Your little sister shovels snow for every neighbor on the block and earns $150. She puts it all in an account earning 6% interest. How much will that original deposit become in 24 years? Answer: about $600 – at 6% compound interest, her money doubles every 12 years (72 ÷ 6 = 12), meaning that her money will double twice over 24 years (from $150 to $300 during the first 12 years and from $300 to $600 during the second 12 years).

There you have it. Simple, yes? Knowing about compound interest and The Rule of 72 can help make you financially successful. Now you just need to borrow your sister’s shovel, so that you can dig up some savings, too!

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