In the following article we guide our reader through the simple yet amazing Rule of 72 and the power of compounding interest. If you are not acquainted with this beautiful truth of investing than prepare yourself to be amazed.
In almost every business transaction that requires an exchange of money these days, you’ll find that a percentage rate is somehow involved. Looking to get a credit card from the retailer of your choice, there’s a percentage rate. Interested in putting some money into a CD or a savings account, there’s a percentage rate involved. Buying a house, investing in a mutual fund, buying a permanent life insurance policy, and even getting a student loan, all are done with an accompanying percentage rate. How do these percentage rates work and how can we quickly and easily figure out how they can help us?
The Rule of 72
First let’s look at the Rule of 72 and the power of compounding interest, which will help determine how well your investments are going to work for you in the coming years.
The Rule of 72 defined: a simple mathematical concept that approximates the number of years it will take your investment to double. That’s all it does, and it doesn’t take a math wizard to figure it out. All you need to do, is divide the number 72 by the nearest whole number in your percentage rate (if it’s 7.25% – just divide by 7; if it’s 8.79%, round up and divide by 9). It may help to have some examples of the rule of 72 in action.
Let’s assume you find a wonderful savings account or CD (Certificate of Deposit) and you want to deposit $8,000. The bank is offering to give you 4% annually on your deposit. (This is 2017, so like we said, this is simply an example. Your interest rate on a CD would probably be close to 2.25%, at best). How long will it take to double your money? In other words, how long will it take to turn your original $8,000 investment into $16,000 with a 4% interest rate?
Using the rule of 72, we would divide 72 by 4 (72 ÷ 4) and get 18. The answer to the question of how many years it would take the money to double, is 18.
Savings accounts aren’t going to give you 4% anymore. In fact, you’ll be lucky to get 1% in most savings accounts. At 1%, it would take 72 years to double your investment (72 ÷ 1 = 72). Which is hardly going to attract any investors.
What if you could get 8% for your money in some sort of mutual fund, annuity, or permanent life insurance policy?
At 8%, your money would double in just 9 years (72 ÷ 8 = 9). Now that’s not so bad.
What if we could get a rate that was 12%? At 12% the money would double in just 6 years (72 ÷ 12 = 6).
And don’t forget that it continues to double every 6 years as long as the rate is consistent. The original investment of $8,000 would be $16,000 in 6 years at 12% interest, and if you let it continue to grow without withdrawal, it would be $32,000 in another 6 years.
The Rule of 72 is used to estimate how quickly your principle amount (the amount you invested initially) will double. It’s important to remember this, because you don’t want to throw your $50,000 inheritance into a savings account earning 1% thinking that you’ll be able to retire on the money in 20 or 30 years (you’d have to wait 72 years just to reach $100,000).
It’s important to keep in mind that a relatively small change in the percentage rate, can result in a significant difference in your earnings over time. Look at the following chart to see the difference in compounding interest between the three different rates.
If given the option to place your money in one of the three different investments, you would clearly pick Investment C over any of the others. We will always choose a higher percentage rate if all other things are equal.
But I want to show the dramatic difference between the first and third choices. Investment A has an initial investment of $10,000 at age 24 and it sits untouched for 36 years. As a result, the investment results in a grand total of $40,000 at age 60.
Investment C started with the same initial investment of $10,000 and it sat untouched for the same period of time. However, the grand total is a whopping $640,000 at age 60. That is a difference of $600,000 over the same time period.
To figure out compound interest you need to arrive at a what your principle is and the interest rate your principle will grow at. As your principle grows due to your interest rate, the new interest is applied to your principle, growing your initial principle to higher levels. The new principle is then increased via your interest rate, which is then reinvested into your principle, giving you an ever increasing principle, that is ever increasing due to the compounding affect of interest returns reinvested into your account.
Now, true compound interest only take place when your principle is left undisturbed.But if your principle goes down, you are not seeing “true” compound interest.
For example, if your principle is $50,000 and is in a mutual fund growing at 10% a year for 7.2 years, how much money will you have after 5 years?
The Rule of 72 can help you make sense of the somewhat confusing world of compounding interest. Let’s do the math: 72 divided by 10 = 7.2 years, so your $50,000 will have doubled. Great job!
But what happens when the stock market crashes and you lose 50%, like many did in the 2008 and 2000 crash? What then?
Your gains of the last 5 years are now completely wiped out!
Let’s do the math again: $100,000 principle divided by 50% = $50,000, your original principle amount. Now what?
In order to get back to the $100,000 you will need your account to double. It took 7.2 years at 10% last time to do this. And in just one year you are back to ground zero. Uuuggghhh!
So what can we do?
Rather than follow the old “buy and hope” model where you give all your money to Wall St and they in turn give you nothing in return, how about trying a new approach?
Now, if you made it this far, at least give me a few more minutes of your time. What I am about to introduce you to is not the easiest thing to understand, at first. But once your mind can overcome all the objections that our society has filled it with, you just might find yourself having an “aha” moment.
So what is infinite banking?
The basic premise is you are both a banker and a investor/consumer. You wear two hats, but being the banker is the most important job you have.
You use a cash value whole life insurance policy that offers a guaranteed rate to act as your own personal bank that you loan yourself money from to buy large ticket items and investments with. Any cash value policy could work but whole life is ideal because it is a non-correlated asset, i.e. not tied to the stock market.
The policy is a “safe” place to store your wealth since it is backed by the most financially sound companies in the world. You can take out a policy loan at 5% from these mutual insurance companies income tax free and buy things, like cars and assets (real estate, dividend stocks, etc…).
You use non-direct recognition companies that still pay you interest and dividends (6-7%) so you start with 1-2% positive arbitrage. Say you buy a car, and charge yourself 8%. You then pay yourself back with interest (because you are the bank and you’re in it to make money).
You make 1-2% arbitrage with your policy and another 8% on interest, paying back your policy loan and adding to your policy cash value and death benefit via paid up additions, that continue to grow your policy.
Over time, your policy grows and grows and you can loan money to family or do whatever.
Maybe you even buy more policies.
Essentially, you capitalize on the guaranteed growth and tax deferred benefits, in addition to the leverage you get with an ever increasing death benefit.
When you die your family is rich because you successfully implemented the infinite banking system into your financial plan.
Back to the Rule of 72
Use the Rule of 72 to your advantage as you sit down and evaluate how your investments are working for you.
Count the number of years you have until retirement and do the math on your own retirement accounts.
You may not have a static interest rate, but you might be able to use an average of the years you’ve invested thus far.
If you don’t know how to get the information on your retirement accounts, grab your statement and look for a phone number to call. Don’t be shy about asking the hard questions about your accounts.
If you don’t have any retirement accounts, give TermLife2Go a call. We have a variety of options that can get you started toward saving for your retirement. At the very least, make sure you take control of your future by looking into it.
The Rule of 72 clearly indicates that the longer your money is working for you, the better off you’ll be.
With the Rule of 72 at your finger tips, perhaps it is time to delve into some other financial pursuits, such as:
The first step in the journey of 1,000 miles is the first step. Don’t delay, start your journey to financial freedom today.
Thank you for reading our article, The Rule of 72 and the Power of Compounding Interest. Please leave any comments or questions below.