There’s a famous money rule you’ll likely have heard of called the Rule of 72. It’s a simple equation that’s actually a valuable tool to help you project interest rates and their output over time.
Many people attempting FIRE use the Rule of 72 to work out how much money they will need to reach their early retirement goal. That’s because it’s a quick method to estimate how long it will take for you to double your money. Naturally ‘how long’ is the key question for any wanting to retire early.
While there are loads of online calculators that will do the maths for you, it’s actually fun to calculate it old-style. Even for maths haters like me! Doing the maths yourself really helps you get your head around some key financial principles, like the power of compounding and the importance of delayed gratification.
How to use the Rule of 72
The actual mathematical formula involved is complex and derives the number of years until doubling based on the Time Value of Money. Fortunately, it can be simplified into a quick calculation.
To use the Rule of 72, you simply divide either years (T) or interest rates (r) into 72 to get the other.
T ≈ 72/r or R ≈ 72/t
For example, divide an interest rate of 10 into 72 and you get 7.2 years, the time it takes the money to double. Working the other way, 7.2 years divided into 72 tells you that you’d need 10 per cent interest to double your money.
The formula is an estimate only (hence use of ≈, rather than =) and it only works for investments that earn compound interest, not simple interest. If you choose to withdraw your earnings rather than reinvest them, the Rule of 72 wouldn’t work.
This simple chart shows how this rate of interest would affect a $1,000 deposit over a period of time at the 10 per cent rate.
In the first 7.2 years only $1,000 is earned, but in the last 7.2 years the interest earned is $64,000. That’s the mighty power of compounding at work.
Benefits of the Rule of 72
The biggest benefit of the Rule of 72 is that it’s quick maths – 72 is a surprisingly easily divisible number.
How long will it take you to double your money at 4 per cent interest? 18 years.
What about 9 per cent interest? 8 years.
It provides a good estimate of what you can expect in most situations, with a few caveats.
The rule is generally accurate for interest rates between 6 and 10 per cent. It becomes less reliable outside of those parameters. Fortunately, most investments fall into this range of return, so it will work for projecting your superannuation balance, or shares and ETF returns.
You can apply it to anything that increases exponentially. So, it works for figuring out GDP or inflation or to indicate the long-term effect of annual fees on an investment’s growth.
Just remember, it’s an estimate only. While you can work them out separately using the rule, you can’t just run one sum that considers all the necessary variables like inflation, fees, taxes or other return-busting nitty gritty.
It’s also worth noting that it only works if your interest is compounding and you’re not adding anything new to your investment over the time period. Which makes the return all the more impressive, don’t you think?