When it comes to saving, the power of compounding interest should never be underestimated. The Rule of 72 can be used as a quick rule of thumb to help determine how long it would take to double your investment at a fixed rate of return. Catch my video below to learn more and I've outlined additional details in this article.
What Is the Rule of 72?
The Rule of 72 is a formula that estimates the amount of time it will take for an investment to double in value when earning a fixed annual rate of return.
72 / interest rate = years to double
If you divide 72 by the annual rate of return, this should give you a general idea of many years it could take for your investment to double in value.
It’s important to note that this is not an exact science, but rather a general estimate and there are scenarios in which a different formula may provide a more accurate answer.
Calculating Time with the Rule of 72
As an example, say someone invests $50,000 in a mutual fund with an estimated annual rate of return of six percent.
Using the Rule of 72 formula, the calculation would appear as:
72 / 6 = 12
Based on this formula, the investor's original investment may be worth $100,000 in around 12 years.
Using this estimation method helps better understand the effects of compounding interest on your investments.
The Rule of 72 Compounding Interest Formula
The Rule of 72 can also be used to estimate how much compound interest your investment earned. For example, if you invested $25,000 and in10 years it grew to $50,000.The formula would appear as:
72 / 10 = 7.2
In this example, your average rate of return was 7.2 percent.
Considerations for the Rule of 72
Before using this formula in the real world, there are a few important considerations to keep in mind.
It's Only an Estimate
This formula is best used in providing a general estimation, as past performance of the market does not guarantee future returns. While you can guess an average rate of return based on market performance or other benchmarks, there is no guarantee. Additionally, studies have found that the Rule of 72 tends to work best for average rates of return between six and 10 percent.1 Outside of this window, a more precise formula may be required.
It's Best for Long-Term Investors
If retirement is around the corner, you’ll likely want a more precise prediction of what your income and savings may look like. This is crucial to identifying potential income gaps and developing a tax-efficient withdrawal plan. Whereas, broad estimations like the Rule of 72 may not be suitable for your needs. In addition, shorter periods of time prior to retirement include less space for market corrections should a downturn occur.
The Rule of 72 can be a helpful tool that investors use to estimate how long an investment with a fixed rate of return may take to double. By using this formula allows you to quickly gauge the potential future value of your investment, however, performance is never guaranteed. While you can quickly get an estimate using this general rule, I recommend working with your trusted financial planner when making decisions that can affect your portfolio. Contact me below if you have questions, or would like to learn more!
AUTHORED BY AUSTIN LINS - ASSOCIATE FINANCIAL ADVISOR