Wealth-Building Power Math: The Rule of 72 (Part 2)
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One of the very best ways to build wealth is to capture the power of Compound Interest and Compound Returns which we covered in Part 1 of this series.
The Rule of 72 is a very helpful way to analyze and then organize your finances to capture the power of compound interest and compound returns.
This handy formula helps you evaluate investments and compare investments.
The Rule of 72 tells you how long – how many years – it will take you to double your money at a particular interest rate or rate of return.
You can also compare the expected rate of return or target rate of return from one investment against the expected rate of return or target rate of return from another investment.
Here’s the Rule of 72 formula:
Years x Annual Rate of Return = 72
In other words, multiply the number of years by the expected annual rate of return; and this equals 72.
This handy formula helps you calculate the:
Number of years it takes to double your money; or the
Rate of return you need to generate (earn) in order to double your money in a specific number of years.
With two of the three numbers – really the number of years in which to double your money; OR an investment’s expected annual rate of return (rate of return per year) in hand, you can calculate the other number (factor).
For example, suppose you have an investment that earns an annual return of 9% or 9.
Using the Rule of 72, if all things go as planned, you can expect your money to double in value in approximately 8 years:
72 divided by 9 = 8 years
On the other hand, suppose you want to double your money in 6 years.
Using the Rule of 72, you would have to make an investment that returns 12% per year.
Drawing on Part 1 of this wealth-building series, using compound rates of return (compound returns), you would have to earn an average annual rate of return of 9% in the first example; and 12% in the second example to achieve your financial goals.
The Rule of 72 can help you:
Estimate how many years it will take to double your money given a certain rate of return.
Estimate the rate of return you will need to double your money in a certain number of years.
Compare investments – analyze one investment opportunity against another. Although as I’m sure you know, keep in mind that there are many factors that go into analyzing an investment, not the least of which is the inherent risk (investment risk) – the likelihood that an investment will pay out as promised; for example, whether the investment will generate the expected rate of return or the promised rate of return.
Calculate how much money you need to save to achieve a financial goal. You can use the Rule of 72 to estimate how much money you have to save to achieve a certain savings goal. Popular financial goals include accumulate a certain amount of money for retirement, save for a down payment for a house, buy a car or fund college tuition.
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Calculating How Much to Invest for Retirement or Another Financial Goal
Suppose you want to save $1,000,000 when you retire, which is 40 years from now and you can earn a rate of return of 7.2% on your investment.
The $1,000,000 is your target amount or “future value” – the amount of money you want to accumulate on or before your target date – the date on which you want to spend the money.
When you implement the Rule of 72, given an annual rate of return of 7.2%, your money would double every 10 years.
Given that your time horizon is 40 years (wealth-building horizon), there are four periods of ten years in which your money will double (assuming you will earn an average rate of return of 7.2% of per year (per annum) and things go as planned).
To figure out how much you have to invest today to accumulate $1,000,000 when you turn 65, halve the target amount or future value; in this case four times:
Age 56 – 65: $1,000,000 divided in half (divide by two) equals $500,000.
Age 46 – 55: $500,000 divided in half equals $250,000.
Age 36 – 45: $250,000 divided in half equals $125,000; and,
Age 26 – 35: $125,000 divided in half equals $62,500.
You have to make the calculation in steps, just like the above example.
If you want to check the math, start with the $62,500 and compound it. So, if it takes 10 years to double your money at an annual rate of return of 7.2%, at the end of the first ten-year period, you’ll have $125,000; then $250,000; and so on.
The examples we’ve discussed in this blog post assume you make a single investment or lump sum investment up front and leave the money intact to grow. Let it ride!
Very Important – If you don’t leave the money intact to grow – for example you make withdrawals – it’s very unlikely you’ll reach your financial goals.
BUT there’s no rule that says you have to invest money only up front, at the beginning, today.
If you really want to create a mountain of wealth for yourself and your family, make a lump sum investment AND make periodic investments, regular investments – perhaps every week or every month!
Payroll deductions are a wonderful way to save money.
Then you’ll really jumpstart your wealth-building and capture the true magic of compound interest and compound returns.
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The Rule of 72 and Debt. . .
Turning the tables upside down, the Rule of 72 can be a sobering experience when you have debt. Costly credit card debt comes to mind. Using the Rule of 72, assuming you don’t make any debt service payments on your credit card debt, you can estimate how many years it would take to double the amount of money you owe.
Suppose your credit card company charges you 24% interest per year. Which is entirely possible these days by the way. Ouch!
If you make interest payments only (interest only payments) on your credit card debt, using the Rule of 72, in approximately three (3) years you would double the amount of money you owe.
Using the Rule of 72, that’s:
72 divided by 24% (or 24) = 3 years.
A mountain of debt and growing.
While it’s unlikely that you would pay only the interest expense on your credit card debt, I think we can agree that the example tells a powerful story.
Oh My Goodness! That’s a very short period of time.
Summing up. . .
The Rule of 72 is a handy, quick way to analyze and compare investments and give you a good estimate of wealth-building – how long it takes you to double your money given a particular rate of return; OR the rate of return you need to double your money in a particular number of years.
Wishing you speedy wealth-building and wealth accumulation!
While you’re at it, to free up more money (cash) for investing to help you reach your financial goals bigger, better and faster, take these easy steps to save more money on groceries. Click here.
See you next week,
Arthur V.
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