What is the rule of 72?
· The Rule of 72 is a simplified version of the more involved compound interest calculation. Good for understanding the effect of compound interest.
· A rule of thumb that helps answer the question how long will it take to double my money?
· Once we know how long it will take to double our money, we need to know how many compounding periods do we have in our lives based on our age, our average rate of return of the investments we play in and our target retirement age?
Simple vs compounded interest
Simple interest is interest earned on the principle.
· Simple interest is determined by multiplying the daily interest rate by the principal amount and by the number of days that elapse between payments.
· It is used for calculating interest on investments where the accumulated interest is not added back to the principal.
For example
Borrowing - If the bank makes a $10,000 car loan for 5 years at 5% with a total monthly payment of $189 that is typically a simple interest loan. $10,000 x 5% interest = $500 per year / 12 months = $42 (rounded) interest payment the first month, but we are also paying principle of $147. The next month we only owe $9,853 ($10,000 - $147). The interest gets recalculated $9,853 x 5% = $492.65 / 12 = $41 (rounded). The interest continues going down and the principle continues going up until the loan is paid off.
Investing - If we buy a Bond which is when we loan money to large companies. We get an semi annual interest return and at the end of the investment period also called the maturity date we get our principal back. This can be 3 months, 1 year or 5 years depending on the bond.
Simple Interest
Positives: Periodic Cash flow when investing. Lower overall interest paid when borrowing.
Negatives: Potential lower overall returns than compounded interest investments.
Compound interest is interest earned on principle and is interest on interest calculated on the initial principal and on the accumulated interest of previous periods of a deposit/investment.
· Since the interest portion gets accumulated in case of compound interest, it raises the principal’s value with each passing month and leads to higher exponential returns overall.
· By not withdrawing the interest every month, the investor is increasing the principal value which helps them earn more interest.
For Example
Borrowing - Credit Cards and Student loans typically use compound interest – When all accrued interest is not paid. For example a credit card with a balance of $1000 dollars at 5% interest = $50 in interest per year. Credit card allows a minimum payment of $10, which means the unpaid interest is $40. This is added to your debt balance which becomes $1040. Note: This can be much worse if card does monthly or daily compounding.
Investing - Mutual Funds or Money Market Accounts – If you reinvest dividends and capital gains then you can earn interest on interest. This is the holy grail. The money you've earned is working for you to grow even more money.
Positives - It can make the invested money grow at a faster rate compared to simple interest. Higher potential overall returns.
Negative No periodic cash flow.
The Rule of 72 as it applies to investments
Remember the Rule of 72 only applies to cases of compound interest, and not to cases of simple interest. It is a rule of thumb. To know how long it takes exactly it gets more complicated. How do we calculate the rule of 72?
72 / rate of return = # years to double our money
Example
· 72 / 12 % return = 6 years more or less
· 72 / 8 % return = 9 years
· 72 / 6% = 12 years
The rule also means if you want your money to double faster than 6 years, you need to find an investment that earns 12%+ per year compounded annually. To properly use the rule to your benefit we need to know the number of doubling periods we have prior to retirement. To calculate that we need to know three things:
· Our current age
· The average rate of return of our preferred investments
· Our target retirement age
Examples
· William a 25-year-old with investments earning an average rate of return of 12% and a target retirement age of 60.
o 72 / 12 % = 6 meaning his money doubles every 6 years
o Doubling periods formula =
60 target retirement age - 25 years current age = 35 years to retirement / 6 years money doubles = 5.83 doubling periods amount of times money doubles from ages 25 to 60
o According to Investor.gov compound interest calculator
o Initial investment of $100,000
o By age 60 at 12% = $5,279,961
o By age 60 at 6% = $768,608
o Difference = $4,511,353 Most people may think since you earned half the return the total should be half of what you would have earned at the higher rate of return. This is not the case due to all the interest on interest growth.
· Dolores a 50-year-old with investments earning an average rate of return of 12% and a target retirement age of 65.
o 72 / 12 % = 6 meaning her money doubles every 6 years
o Doubling periods formula =
65 target retirement age – 50 = 15 / 6 = 2.5
o According to Investor.gov compound interest calculator
o Initial investment of $100,000
o By age 65 at 12% = $547,356
o By age 65 at 6% = $239,655
o Difference = $307,701 Dolores accumulated significantly less money than William because she did not have as many doubling periods. The best friend of compound interest is time. Don't worry about Dolores as she also has other investments. :)
Assumptions – Annual Compounding, No periodic investments.
Beware of the final years before retirement with too much fluctuation. We may want to consider moving into investments with less fluctuation as the market could crash. If that happens and we are withdrawing our funds it could deplete our money fast.
The 72-rule working against you
· Debt Debt Debt. If you have a high interest credit card 72 / 20% credit card rate = 3.6 years This means that the balance doubles every 3.6 years if not paid down. It could even be worse depending on house interest compounds. Sometimes it compounds daily. Ouch.
· $15,000 will become $30,000 in 3.6 years and $60,000 in 7.2 years
· This is why having debt with set payoff date using simple interest is typically better.
Investments Types with Compound or Simple Interest Returns
Compound interest
· Mutual funds, Index Funds, Exchange Traded funds
· Hedge funds
· Money Market Accounts
· Certificates of Deposit (CD)
· Zero Coupon Bonds
Simple Interest
· Loan made to person or company with monthly interest payments
· Syndicated investment in apartment buildings where you receive quarterly distributions.
· Equity ownership in a startup or private company with quarterly distributions
· Bonds
· Stocks
· REITS
Some investments offering simple interests returns like Syndicated apartment investments which we structure have other benefits such as:
· Above average market returns
· tax benefits from depreciation and 1031 exchanges
· less fluctuation of returns due to people needing a place to live
· diversification from the stock market by owning a physical asset
· inflation adjusted returns or hedge
· Professional Asset & Property Management
Hybrid Way to use the Rule of 72
Buy investment A with simple interest and reinvest cash flow in investment B with compound interest. Example Syndicated investment that provides cash flow and part of sale profit.
If I don’t need cash flow, I will invest the simple interest returns from the apartment building in an index fund generating a historical 12% return. This combines the benefits of simple interest returns with compound interest returns if you don’t need the periodic cash flow.
What should I invest in? It depends.
1. Find what you are comfortable with.
2. Determine what type of returns you want.
3. Try to obtain the highest return with the least amount of risk. Risk can be Reduced in all types of investments.
4. Learn about investments that fit your goals. Focus on a maximum of one or two at time once mastered move on to the next.
5. Diversify & focus. If you hate real estate but want to need to diversify maybe try investing in REITS. If you want to diversify in real estate invest in different asset classes in different geographic areas.
Other fun stuff to use the rule of 72 for
· Use it to calculate how fast the economy is going to grow in size. Economic growth based on GDP? 72 / GDP growth rate
· Can use to calculate loss of buying power of a currency based on rate of inflation.
72 / 2% inflation rate = 36 years so in 36 years a $100 is now only worth $50 in buying power. Wow!
Things to remember
It is not for simple interest investments it is for compound interest investments.
It's important to understand that the compounding is at work in scenarios other than interest, too. Think, for example, of stocks that pay dividends. If you reinvest your dividend payments into shares of more stock, then those shares will grow, too, ideally kicking out dividend payments of their own.
The reinvestment can help your portfolio grow faster than it otherwise would, if you didn't reinvest those sums.