Let’s say you sit down with a friend to discuss investment options over coffee (that is what most kids talk about these days, right?). And as you wrack your brain and furiously scribble numbers on a napkin, trying to figure out which would be a better investment, they calmly blurt out “aha, well obviously Option C would double my money in 5 years!” While math can pretty much feel like sorcery sometimes, your buddy most likely just used the Rule of 72.
What is the Rule of 72?
To put things simply, the Rule of 72 is a quick and easy way to mentally calculate the time in years that it will take for an investment to double given a uniform annual interest rate (we can’t overstate how much we LOVE “quick and easy” here at the Academy, and you should, too!).
For example, we can determine that a $1,000 investment with a 6% rate of return would take 12 years to double in value by dividing the magic number 72 by the given rate (expressed in whole numbers).
This is what the math would look like in equation form:
72 / 6 (rate in %) = 12
72 / (interest or return rate) = (years to double)
In reality, it will actually take closer to 11.9 years for your $1,000 to grow to $2,000 at 6% interest, so the Rule of 72 is not exactly precise (it’s just easier to divide 72 than it is 69.3 – again, quick and easy!).
However, the results are often quite close enough to give you a reasonable estimate, at least until you have the chance to sit down and do the hard math on a spreadsheet.
After all, you wouldn’t really base all of your investment decisions on pure mental math, would you? (If you were actually planning to do that, it’s our sacred job to tell you not to!)
Why is the Rule of 72 useful?
The Rule of 72 presents a somewhat easier way to account for the mysterious (ed: not really) phenomenon of compound interest; that is, interest earned on the principal plus interest already earned.
In case you aren’t familiar with compound interest yet, Albert Einstein, himself, is often cited as being the one who described the snowballing effect of compounding interest as “the most powerful force in the universe.”
That quote might be exaggerated (and probably misattributed, for that matter), but the effects of earning or paying interest on increasingly larger balances can really make a difference on long-term investments or loans.
Read also: ROI: What is the return of your investment?
On the same $1,000 principal from earlier, you can expect to earn $60 after the first year. But, compounding kicks in after that and you get $63.6 interest the second year. By the 5th year, you’d earn $75.75 in interest alone.
This $15.75 difference means you already earn 26.25% more than your first-year gain. Now imagine how much greater your earnings would be playing with bigger amounts and longer timelines!
How else can the Rule of 72 be used?
Once you get the hang of playing around with factors of 72, you can take a look at how this simple equation can also be applied to different problems.
For example, you can calculate how long it will take inflation to halve the value of a principal. We can apply this to the same $1,000 investment in an environment experiencing inflation at 2%, and determine that it would take about 36 years for the value to halve:
72 / 2 = 36
72 / (inflation rate) = (years to halve value)
This is important to understand, because inflation is essentially a measure of the rate at which the value of a given currency gradually decreases over time. Inflation tends to stealthily eat away at returns on investment, meaning that for example, earning 2% interest in a 3% inflation economy actually produces a negative inflation-adjusted result. As such, investors therefore need to understand inflation in order to seek out methods to mitigate its effects.
Using the same equation, we can also estimate how long compound interest would take to cause the value of a debt to double. This is especially useful for people dealing with loans and credit card debt, for example. Let’s say that you fail to pay back a $1,000 purchase on your credit card that charges 12% interest per annum—it will only take 6 years for your original debt to double!
72 / 12 = 6
Having an available credit line is undoubtedly practical in cash-tight situations, but studies show that consumers can end up spending 100% more on credit than with cash.
We strongly recommend preventing yourself from getting buried in credit card debt by paying for everyday transactions with cash or your debit card and strictly reserving your credit card for emergencies. And when you do use your credit card, try to pay your bills on time!
A better rule?
We mentioned earlier that 69.3 may be a more accurate “rule,” but even the “Rule of 69.3” is only true when you’re evaluating lower rates. Nothing will beat going through the actual logarithmic equations with a little (or a ton of) help from a calculator or spreadsheet.
However, the Rule of 72 was adopted as a reasonably accurate shorthand method of determining these far-off values and timelines using simple back-of-the-envelope math.
Remember that when estimating compound interest over decades, there are always several factors that can tweak actual results along the way. This can include inflation and other external factors. But for the purposes of a novice investor this rule tends to work quite well.