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Compound Interest is King

Jodie Nolan - Tuesday, April 28, 2015

Compound Interest is King

The MAGIC Rule of 72

Compound interest helps you build wealth faster. Interest is paid on previously earned interest as well as on the original deposit or investment you made. So if you deposited $5000 into a bank account at 6 per cent interest for 12 months you earn $308. If the interest is being compounded monthly in just five years your $5000 will grow to $6744.

On the flip side, this is how interest is also charged to your credit cards and mortgages.

The Rule of 72 – the nature of compound interest – is a brilliant way for you to roughly estimate how your investment will grow over time. Simply divide the number 72 by your investment’s expected rate of return to find out how many approximate years it will take for your investment to double in value. So if you invest $5000 today at 8 per cent, your investment will double every nine years (72/8 = 9).

The Rule of 72 is a great way to quickly estimate the effect of any growth rate, from quick financial calculations to population estimates. Here’s the magic formula:

Years to double = 72/interest rate

This formula is useful for financial estimates and understanding the nature of compound interest.

Some further examples:

At 6 per cent interest, your money takes 12 years to double (72/6 = 12).

Then, to double your money in 10 years, you need an interest rate of 72/10 or 7.2 per cent.

If your country’s GDP grows at 3 per cent a year, the economy doubles in 24 years (72/3 = 24).

If your growth slips to 2 per cent, it will double in 36 years. If growth increases to 4 per cent, the economy doubles in 18 years. Given the speed at which technology advances, it is important to consider how quickly an economy is growing.

You can also use the rule of 72 for expenses, like inflation or interest:

If inflation rates go from 2 per cent to 3 per cent, your money will lose half its value in 36 or 24 years.

If you pay 15 per cent interest on your credit cards, the amount you owe will double in only 72/15 or 4.8 years!

The rule of 72 shows why even a small 1 per cent difference in inflation or GDP has a huge effect in forecasting models and applies to anything that grows, including population.

Can you see why a population growth rate of 3 per cent Vs 2 per cent could be a huge problem for planning? Instead of needing to double your capacity in 36 years, you only have 24. Twelve years were shaved off your schedule with one percentage point – amazing stuff to know and understand!

Practical examples of the Rule of 72 in action

Q: Mary S. Investor needs to double her money in seven years to reach her financial goals. What rate of return must she earn to do this successfully?

A: Mary would take 72 divided by 7; and the answer is 10.2857 per cent – so 10.29 per cent is the amount she will need to earn on an after-tax basis to successfully reach her goal.

Q: Bill M. Investor is earning a 9 per cent after-tax return on his investments. How long will it take him to double his money?

A: To calculate the number of years necessary to double his money using  the Rule of 72, Bill would divide 72 by 9; the answer, 8, is the number of years it will take for his investment to double after taxes.

Generally, investment portfolios generate income and capital growth. If you reinvest the income payable (instead of taking it to spend) and leave the investments to compound you will gain more income and growth on that original amount and your overall total wealth or investment balance will therefore increase at an astonishingly fast rate.

It is the magic of compounding interest and time in the market. Interestingly, if you were to invest $1000 in Australian shares 50 years ago, it would now be worth approx $150,000, earning the same as the All Ordinaries Index with returns being reinvested. If you took into account inflation, that $1000 should really only be approx $32,000 after 50 years, so the additional $118,000 is the effect from compound interest and capital growth.

As a result, you really need to start sooner rather than later as the best support to compounding interest is time. 

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