Tuesday, February 17, 2009

Compound Interest and the Rule of 72

It's rumored that Albert Einstein once said that "the most powerful force in the universe is compound interest" -- a bold claim, considering most are unaware of the virtues of such a phenomenon. But to truly understand this "8th wonder of the world," or so Einstein called it, you need a basic understanding of what it is, like everything else in finance!

If you're saving, compound interest is literally your best friend. Granted, you may not be able to call it on the phone to grab the occasional lunch with or gossip with it over a manicure about a pair of shoes you saw at Bloomingdale's, but in terms of your money, compound interest really is your new BFF. It's like the Ethel to your Lucy, the Robin to your Batman, the Nicole Ritchie to your Paris Hilton. Okay, enough with the examples (especially that last one).

According to the Merriam-Webster Dictionary, compound interest is defined as "interest computed on the sum of an original principal and accrued interest." Zzzzzzzz (cue crickets chirping in background). "What in God's name does that mean?" you ask -- either that, or you're already nodding off with boredom at your computer, and if the latter is the case -- snap out of it.
Compound interest is a simple and painless way to make tons of cash back on your savings. How? Well, it's simple. Compound interest is money that you gain not only on your initial investment, but also on the interest that's already accumulated on it. If it sounds confusing, here's an example to assuage your "huh?":

Say you have two 22-year-olds . . . let's call them Simon and Garfunkel. Simon makes the most of his 20s and saves and invests $2,000 each year until he's 31, then stops. Lackadaisical Garfunkel, who enjoyed his 20s spending money instead of saving, starts investing $2,000 per year starting at 31 until he's 65. Both have identical rates and both allow interest to grow. Forward-thinking Simon will earn $50,000 more than Garfunkel by the time he's 65, even though Garfunkel will have put $50,000 more into the account over an added 25 years.

You know that saying "a rolling stone gathers no moss?" Well in the case of compounded interest it does, and it's a good thing. Compound interest acts like the moss your savings accumulates throughout the years. Shine on, you crazy diamond!

The two most important factors to remember when daydreaming about compound interest on a sunny afternoon, are:

  • Time -- The younger you start saving, the more time your money will have to grow, or compound. Time really is on your side, or so said the Rolling Stones.
  • Rate of Return -- What kind of rate of return is your investment giving back to you? Historically, the stock market yields about 11% per year, savings accounts give you about 3% per year, and so on. Rate of return is important because with the total amount that your money grows each year, the amount that is added from interest grows along with it. So it comes as no surprise that the higher the return rate, the faster your money grows.
    Unfortunately, finding a good investment with a high rate of return isn't as easy as looking into the underbelly of a Magic 8 ball for the answer. But there is a trick called the The Rule of 72 that you can keep up your cashmere sweater sleeve next time you're determining how good or bad a potential investment will probably be.

If you want to figure out how many years it will take to double your money at a certain interest rate, all you have to do is divide the rate into 72. Say you want to see how many years it will take to double your money with a 6% interest rate -- you'd just divide 6 into 72 and get 12 years time to double your money. Come for cocktails, stay for the deviled eggs, chickadees!

The Rule of 72 also works in reverse. If you want to see what kind of interest rate you'd need for a set amount of years to double your money, you'd take the number of years (let's say 8), divide that number into 72 and poof! You'd need a 9% interest rate to double your money in eight years. The Rule is fabulously simple yet timeless, just like a Chanel suit. As long as the interest rate is less than 20%, it's generally quite accurate.

With compound interest, just remember that the name of the game is to invest young and often (time is a key player here), in an investment with a high rate of return. Picture your money as a snowball you start patting together in your 20s. The older you get, the more snow gets patted onto it that by the time you're ready to retire, the snowball is so big from years and years of fresh snow, that it's more of an igloo than a snowball. And it will be ready for you to call it home!


Petunia 100 said...

You know, it really bodes well for your future that at your age you already know this stuff. Good for you.

At 18, my daughter "knows" because I have told her and told her, but I am pretty sure what she hears is "blah blah blahbitty-blah".

Do you have an asset allocation plan in place? Do you talk about it elsewhere on your blog? (If so, please just point me.)

Crystal said...

Thank you! Your daughter is only 18, just give her a few more years. I'm sure in her early 20s it will all begin to click. I haven't published my asset allocations, but they are spread between my 401(k), CDs, stocks and real estate.

Michael Ejercito said...

The Rule of 72 is most accurate for a rate of return of 7.85%, and is generally accurate for interest rates of 6% to 10% with a margin of error of about one month.

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