TODAY, let us revisit an earlier example provided in explaining compound interest. By extending and revising this example, an explanation of an important rule is presented: the compound interest rule of 72.
In the chart below, Column 1 tracks the year of the investment return; Column 2 presents the investment balance at the end of the related year when $5 000 is invested at ten per cent simple interest. Column 3 represents the balances per year for the same investment at ten per cent interest compounded annually; Column 4 presents the difference in earnings between simple and compound earnings at ten per cent; and Column 5 presents the results if the investment was compounded annually at 12 per cent.
The interest rule of 72 can save the trouble of making such involved mathematical calculations. This rule of 72 applies to compound interest and says that ‘the rate of interest on an investment’ R multiplied by ‘the number of years for your investment to double in value’ T equals 72: RxT = 72 or alternately: T = 72/R or R = 72/T.
As shown in the chart, Column 3, at ten per cent the $5 000 investment would take approximately 72/10 =7.2 years to double. Alternately, if the aim is to double the $5 000 investment in six years, the return on the investment would have to be about 72/6 =12 per cent, reference Column 5.
This rule is exceedingly useful in assessing how comparably good proposed investments are in advancing your financial goals. It allows you to assess the benefit of extending your risk tolerance to gather another point or two in the return rate.
A simple example bears out this point: Consider the $5 000 was invested at three per cent, or at six per cent. At the three per cent return, after 24 (72/3) years the investment would have grown to $10 000 and to $20 000 after another 24 years later and so on, doubling every 24 years or so. Similarly, can you now work out the growth if the return was six per cent?
If you have done your assessment right, you may be startled to find that after 48 years the investment at three per cent would be worth about $20 000, Â whereas the investment at six per cent would be worth about $80 000.
The rule of 72 is amazingly important in attempting to control your finances. So we will come back to this chart and related examples again.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.
