When it comes to saving money, taking advantage of compound interest is a brilliant thing. It’s often one of the easiest and simplest ways to “use your money to make money that makes money”. Compound interest can also work against you. Most revolving credit contracts – such as credit card companies – use the compound interest methodology. If you don’t pay off your balance in full you are charged interest – if you do it this again the following month you will be paying interest on not only your principal BUT also on your past accrued interest. It’s how they make their money.
Back to making money and not losing it! The Rule of 72
This tool can be very effective in helping you make decisions on your finances when using compound interest. If you are working with a given interest rate, you can easily use the Rule of 72 to figure out how long it will take to double your money.
Some simple math. Take 72 and divide it by the promised interest rate on your investment dollars. A good example would be if you decide to invest some money in a friend’s business – you provide them a loan with a 10% interest rate. You would take the number 72, divide it by the interest rate – which is 10, and get 7.2 – that’s the number of years it would take to double the value of your investment.
The rule of 72 works in the reverse as well. If you are promised by someone that they will double your money in a certain number of years, you can determine what interest rate you’d need to receive in order to meet that timeline. Example: You invest $20,000 as a loan and are promised that in 5 years, you will double your money. You take 72, divide it by 5 years – this is the interest rate that you would need to receive on the $20,000 – which is 14.4% to actually double your money.
There are so many ways that you can use the Rule of 72! You can even use it to help with funding your retirement. Assume you are 30 years old and you have $500,000 in a 401k that typically earns you a 10% annual return. Assume you will work until you are 65 and not touch that $500,000 until then. How much money would that be when you retire?
Using the rule of 72, we divide 72 by 10 (interest rate) and determine that every 7.2 years your money will double. Since you plan to work another 35 years, your money will double in value about 5 times – you’ll have $1 million after 7 years, $2 million after 14 years, $4 million after 21 years, $8 million after 28 years, and by retirement, you should have $16 million dollars.
Compound interest is a pretty amazing thing. There is a lot of power in starting to save money as early as you can so that it can compound over your lifetime. If you have questions on how compound interest works – both for you or against you – give us a call. We would love to help you make your money work for you!
Litchfield Branch Manager, Vice President