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In its simplest form, the rule of 72 states that if you know what the compound interest rate is, you can determine how long it will take to double your investment by dividing 72 by the interest rate. Right away, you will realize that given a 10% compound interest rate you will double your money in 7.2 (72/10) years.
Assume an initial investment of $10,000 at an interest rate (compounded) of 6%; you can determine the length of time to double your investment by dividing 72 by 6:
72 / 6 = 12
It will take exactly 12 years to double $10,000 at an annual compound interest rate of 6%.
This is neat, isn’t it? Great stuff.
The rule of ‘72 also works in the reverse.
Assume that you have an initial investment of $12,000 and you want to double it in 9 years, what interest rate would you be looking for?
Answer: 72 / 9 = 8
As the investor, you will be looking to secure an interest rate of 8% over the life of your investment. This will result in the doubling of your investment in nine (9) years. Again, you may test the accuracy of the Rule of '72 by using our Compound Interest Table.
By now, you may be saying this is the best thing you have come across in a while...real simple isn't it? Well, as you know life is not that simple so there have to be a catch somewhere, and there is. The Rule of '72 does have some limitations.
While the rule is fairly accurate for interest rates below 20%, the accuracy starts to decline at just about 20% and gets worse as the interest rate increases. For calculations resulting in or using interest rates below 20%, the results are extremely accurate. However, for calculations resulting in or using interest rates at 20% or above the results are less and less accurate as the interest rate gets higher and higher.
The table below compares the Rule of ’72 calculation with the result from the Compound Interest Table. You will realize that the discrepancy between the two results widens as the interest rate exceeds 20%.
The Rule of '72 and the Compound Interest Calculation - A comparison
| Scenario |
Rule of '72 |
Compound Interest Table |
Difference |
To double $12K in 9 years - what interest rate would you need?
|
8.00% |
8.01% |
0.01% |
To double $12K in 4 years - what interest rate would you need?
|
18.00% |
18.92% |
0.92% |
To double $12K in 3 years - what interest rate would you need?
|
24.00% |
25.99% |
1.99% |
| To double $12K in 2 years - what interest rate would you need? |
36.00% |
41.42% |
5.42% |
|
The Rule of 72 is an interesting and easy way to determine the interest rate, but the real message from the above should be the power of compounding. The world’s most renowned genius, Albert Einstein referred to compounding as the “most powerful force in the universe.” This quote may be stretching it a little, but it certainly isn’t far from the truth.
Compounding is a very important part of the investment process, and every serious investor should understand and seek out the benefits of compounding. Compounding can add significant growth to your investment when compared to simple interest.
Consider the following:
$1,000 invested at a compound interest rate of 10% (compounded annually) for 20 years will return $6,727.50. The same amount invested at a simple interest rate of 10% annually for 20 years will return only $3,000! That’s a HUGE difference.
To say the same thing another way; It will require an annual simple interest rate of 28.64% to provide the same result as a compound interest rate of 10% (compounded annually) on an investment over 20 years.
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