Rule of 72 - Explained
What is the Rule of 72?
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What is the Rule of 72?
It is a simple calculation method to estimate an investments doubling time with a specific fixed annual interest rate. It is the easiest and fastest way to calculate how long an investment will take to double, given a fixed annual rate of interest. The formula for calculating the time is, The estimated number of years needed for doubling the investment = 72 / compound interest rate. The same formula can be used for estimating the annual rate of interest needed for doubling an amount within a specific time period. The estimated compound rate of interest needed for doubling the money = 72 / Number of years.
How Does the Rule of 72 Work?
Compound interest means, earning interest on interest. If you get 10% interest a year, then your investment of $100 will become $110 in one year and then in next year, your interest will be calculated on the principal amount of $110 and so on. Three main elements are there that impacts the growth: the rate of interest, how frequently it is to be compounded, and how long the account is allowed to compound. The Rule of 72 uses the concept of natural logarithms. The logarithm is the opposite concept of power. The natural logarithm can be explained as the amount of time needed to reach a certain level of growth with continuous compounding. The Rule of 72 gives a rough estimate rather than the exact figure. The formula is useful for doing a mental math to estimate the time. For doing this calculation, one needs to figure out the compound interest rate and put it as a whole number and not as a decimal. For example, if someone invests $1 at an annual compound interest rate of 10%, according to Rule of 72 the estimated number of years it will take to become $2 is, 72 / 10 = 7.2 years. However, in reality, it will take 7.3 years to get double.
In general, the Rule of 72 is almost accurate for the interest rates that fall between 6% and 10%. For other interest rates, the rule can be adjusted by adding or subtracting 1 from 72 for every 3 points the rate of interest diverges from 8%. Some people also use the rule of 69.3 to get a more accurate result for continuous compounding. For the sake of simplicity, some may also substitute it with 69. However, 72 is a convenient number as it has the small divisors like 1, 2, 3, 4, 6, 8 and 9. It makes the calculation simple and easy.