Have you heard of rule of 72 before? You might have or might not. If you have you might not fully understand what it means. In financial terms, Rule of 72 is a simplified method for estimating the doubling times for compounding interest. The rule of 72 can be used in 2 ways.
72/ (number of years to double) = Interest rate in percentage
On the other hand, you can apply the rule of 72 this way
72 / (Interest Rate) = No. of years for money to double
In the article titled compound interest, I explained the difference between simple interest and compound interest. I showed how interest is compounded in long form calculation. The calculation below shows step by step how this is achieved. Most people don’t have a financial calculator (although it is a good idea to have one) or carry their laptop with them all the time. In such circumstances, you can use the rule of 72 for a close estimate.
Let’s apply the rule of 72. In the previous example, assuming you invest 10,000, and the interest rate is 12% a year, the step by step calculation is as follows:
Year 1. 10,000 x 12% = $11,200
Year 2. 11,200 x 12% = $12,544
Year 3. 12,544 x 12% = $14,049
Year 4. 14,049 x 12% = $15,735
Year 5. 15,725 x 12% = $17,623
Year 6. 17, 623 x 12% = $19,738 or approximately 20,000
Use the rule of 72 and this becomes fast and simple. Take the figure 72, divide it by the number of years i.e. 72/6 = 12%. The figure you get is the interest rate compounded yearly. In the formula, use the numeric for interest rate. Ignore the percentage. So if the interest rate is 12%, then it is 72 divide by 12, not 12%. What you’ll get is the number of year your money will double its value. You can try it for different interest rate and see that the results are fairly accurate.
The rule of 72 can also be used to estimate the time where your value of money is halved its original value. If the inflation rate is 5%, then the number of years it takes for your money to be half its value is 72/5 approximately 14.2 years. So if you have $10,000 today, and you invest it an low interest rate vehicle, then, in slightly more than 14 years, your money will be worth only $5,000.
All the more reason to manage your money well. Remember to use you rule of 72