Simple interest is paid just on the principal amount. With compound interest, the return that you receive on your initial investment is automatically reinvested—you receive interest on the interest.
Compound interest is critical to investment growth. Whether your financial portfolio consists solely of a savings account or a number of highly leveraged investments, your total return is dramatically improved by the compounding factor.
But just how quickly does your money grow? The easiest way to estimate that is by using what’s known as the “Rule of 72.” Quite simply, the rule enables you to determine how long it will take the money you’ve invested on a compound-interest basis to double. You divide 72 by the interest rate to get the answer.
For example, if you invest $10,000 at 8 percent compound interest, the “Rule of 72” reveals that you will have $20,000 in nine years. You divide 72 by 8 percent to get the time it takes for your money to double. The “Rule of 72” is a rule of thumb that gives approximate results. It is most accurate for hypothetical rates between 5 and 20 percent.
While compound interest is a great ally to an investor, inflation is one of the greatest enemies. The “Rule of 72” can also highlight the damage that inflation can do.
Let’s say you decide not to invest your $10,000, but hide it under your mattress instead. Assuming an inflation rate of 4.5 percent, in 16 years, your $10,000 will have lost half of its value. Inflation will reduce its purchasing power.
The real rate of return is the key to how quickly the value of your investment will grow. If you are receiving 10 percent interest on an investment, but inflation is running at 4 percent, then your real rate of return is 6 percent. It will take your money 12 years to double in value.
The “Rule of 72” is a quick and easy way to determine the value of compound interest over time. By taking the real rate of return into consideration (nominal interest less inflation), you can see how soon a particular investment will double in value.