In finance, the Rule of 72 is a formula that estimates the amount of time it takes for an investment to double in value, earning a fixed annual rate of return. The rule is a shortcut, or back-of-the-envelope, calculation to determine the amount of time for an investment to double in value. The simple calculation is dividing 72 by the annual interest rate.
Rule of 72
The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to duplicate itself.
How to calculate using the Rule of 72?
To determine the Rule of 72, divide 72 by the bank savings interest rate. You can use the Rule of 72 formula given below to compute the time in days, months, or years to double your investments. Enter the annualised interest rate, and you will get the length of time it will take to double your investments.
N = 72 / r
Where:
N is the number of intervals, which is usually years; 72 is a constant; r is the rate of interest.
For instance, you can employ the Rule of 72 to calculate how long it will require for a currency’s purchasing power to be half owing to inflation, or how long it will take for the combined worth of a universal life insurance policy to fall by half. Just substitute the inflation rate for the rate of return, and you will obtain an estimate of how long it will take for the starting sum to drop half its value.
How to Adjust the Rule of 72 for Higher Accuracy?
The Rule of 72 is more accurate if it is adjusted to more closely resemble the compound interest formula which effectively transforms the Rule of 72 into the Rule of 69.3.
Many investors prefer to use the Rule of 69.3 rather than the Rule of 72. For maximum accuracy particularly for continuous compounding interest rate instruments use the Rule of 69.3.
The number 72 has many convenient factors including two, three, four, six, and nine. This convenience makes it easier to use the Rule of 72 for a close approximation of compounding periods.
The inner workings of the Rule of 72 in finance
Compounding helps your investment increase because interest is effectively added to your principal and used as the basis for further interest computations. Meaning the pace of growth accelerates as interest accumulates and your money increases. If you reinvest the profits from your holdings, for instance, your profits are compounded. As a result, the Rule of 72 comes into play. Keep in mind, though, if you opt to take out your dividends instead of reinvesting them, your earnings may not compound, and the Rule of 72 may not apply.
It is preferable if interest rates, or rates of return, are between 6% and 10%. It is the return range for most investment accounts, such as retirement accounts, index funds, brokerage accounts, and mutual funds.
Example:
The average interest rate for credit cards is 17.3%. If you divide 72 by that rate, you get 4.16 years. That’s all it takes for a credit card company to earn double your money. The higher the interest rate, the more you’ll owe to your lenders.
If you have debt, look into the possibility of refinancing your car loan or mortgage to get a lower interest rate.
The “Rule of 72” is a practical eye opener that forces you to ask shrewd questions before making important money decisions. If you understand and apply it to your personal finances you’re less likely to fall for gimmicky promotions from banks, settle for opportunities that don’t give you the advantage, and take on debt that might take forever to pay off.