The Rule of 72 is a traditional way to calculate how long it will take for money invested to double in value. It works by dividing the number 72 into the interest rate to determine how many years it takes to double. For example, if you invest $1,000 at 10% per year, it would take 7.2 years to double in value (72/10 = 7.2).
This calculation is easy for people to grasp and is a simple work around that helps many quickly understand the value of an investment or financial asset. But is it the best way to calculate compound interest and how it affects our finances?
What is Compound Interest?
Compound Interest truly is a captivating subject with an abundance of literature dedicated to it. Yet, at its core, it’s a straightforward concept. Interest is essentially the fee a borrower pays to a lender for the privilege of using their money. Over time, this interest doesn’t just sit idle—it grows alongside the original sum.
Let’s take an example: suppose you borrow $1000 at an annual interest rate of 12% for a span of 10 years. Here, with each passing year, a 12% interest on the remaining balance is added to that balance for the upcoming year.
So, every year, the amount you’re required to pay back isn’t merely the original loan amount—it’s the original sum plus the interest that has accrued, making the total sum owed a bit larger with each passing year. This is the magic of compound interest—it’s not just the principal amount that’s working here, but the interest earned so far, joining forces with the principal, pushing the total amount higher and higher as time marches on.
History of the Rule of 72
The Rule of 72 has been used since ancient times; the first written record of it was in India during the 5th century BC. However, it wasn’t until 1872 when mathematician William Stanley Jevons published his book, The Theory of Interest, that people started using it as a method to calculate compound interest. Since then, it has become one of the most popular ways to calculate compound interest.
Why Do People Like this Method?
The allure of the Rule of 72 lies in its simplicity and speed. In a world where investment opportunities come and go in the blink of an eye, having a quick mental tool to gauge the potential of an investment is invaluable. By merely dividing 72 by the annual rate of return, investors get a rough estimate of how many years it will take for their investment to double in value. This ease of calculation enables investors to make swift comparisons between different investment opportunities even when they are on the go, without the need for complex calculations or financial software.
Moreover, the Rule of 72 provides a reasonable approximation that helps in gaining an immediate understanding of an investment’s potential, which is often good enough to make informed decisions in a timely manner. While it may lack the precision of more detailed financial analysis, the rule strikes a balance between accuracy and speed, which is often a necessity in the fast-paced world of investing. Hence, the Rule of 72 remains a favorite amongst investors, providing a quick, intuitive grasp of an investment’s doubling potential, aiding in the rapid assessment and comparison of investment opportunities in a highly dynamic market landscape.
Is There an Alternative?
While the Rule of 72 is easy to use, there are other ways to calculate compound interest. One alternative is the Rule of 70, which calculates compound interest by dividing the number of years into 72 equal parts. Another method is the Rule of 20, which divides the number of years into 20 equal parts. These methods are less accurate than the Rule of 72 because they do not account for compounding periods longer than two years. However, these alternatives are still useful for calculating simple interest rates.
However, this is the 21st Century, we all have computing power at our finger tips. Isn’t there an easy way to get something more accurate quickly? Sure. You can use the NPER formula or function in Numbers or Excel.
Using NPER to Calculate Compound Interest
NPER is the Spreadsheet function or formula that has been widely available in all major Spreadsheet softwares. It stands for Number of Periods for a Loan or Investment, and it has 5 variables or inputs.
Rate (Required). The interest rate per period, most of the time you will have an annual interest rate and you’ll need to divide that by 12. Let’s say for this example our interest rate is 7.2%. That would mean in our formula to get 1/12 of that number we will simply divide it by 12 or 7.2/12.
Pmt (Required). The payment made each period; it cannot change over the life of the annuity. Typically, pmt contains principal and interest but no other fees or taxes. For our purposes this will be 0.
Pv (Required). The present value, or the lump-sum amount that a series of future payments is worth right now. This is be the initial value of the investment, however, it must be negative. For our purposes let’s say the initial investment is $5000, so for this variable we are going to insert a value of -$5000.
Fv (Optional). The future value, or a cash balance you want to attain after the last payment is made. If fv is omitted, it is assumed to be 0 (the future value of a loan, for example, is 0). While this is an optional value, for this to calculate correctly for us we need to make this double our initial investment but as a positive number. So, for our example, we are going to use the value of $10000.
Type(Optional). The number 0 or 1 and indicates when payments are due. We will omit this value in our example.
The our formula will look like this:
So, if you haven’t before, I hope you that you’ll use the rule of 72 to quickly assess an investment, but write that spreadsheet formula out to get it correct where it counts!