Barbara O’Neill, Ph.D., CFP® Extension Specialist in Financial Resource Management Rutgers Cooperative Extension
Have you heard of “The Rule of 72”? It is a simple formula that can be used to estimate either the interest rate or the time period required for a sum of money (any amount) to double. Simply divide one of these two variables (i.e., interest rate or time period) into 72 to solve for the unknown variable. The Rule of 72 is accurate for interest rates below about 20%, which corresponds to commonplace earnings on investments
The number used for the interest rate variable may be known (e.g., the stated rate on a bond or certificate of deposit) or assumed (e.g., average annual stock returns). The time frame can match the target set for achieving a specific financial goal such as buying a home or when a child starts college.
As the interest rate earned on an investment decreases, the time required for a sum of money (any amount) to double lengthens. For example, it takes 9 years to double a sum of money with an 8% rate of return (72 divided by 8) and 18 years to double it at a 4% rate of return (72 divided by 4).
Let's use the Rule of 72 to examine how $2,000 could grow over an investor's lifetime. If a $2,000 investment is made at age 22 and earns an average 8% return, an investor would have the following approximate amounts:
- $4,000 at age 31 (nine years later)
- $8,000 at age 40 (nine more years)
- $16,000 at age 49 (nine more years)
- $32,000 at age 58 (nine more years)
- $64,000 at age 67 (nine more years)
Note that age 67 is currently the full retirement age (FRA) for persons born in 1960 or later to receive an unreduced Social Security benefit. It is, thus, a target retirement age for many young adults.
If a $2,000 investment is made at age 31, instead of age 22, and earns an average 8% return, an investor would have the following approximate amounts:
- $4,000 at age 40 (nine years later)
- $8,000 at age 49 (nine more years)
- $16,000 at age 58 (nine more years)
- $32,000 at age 67 (nine more years)
Note that the late starter's savings is just half of the first investor's amount. The second investor lost the last doubling period, where the real payoff occurs, by waiting an extra decade to start investing. In other words, procrastination is very costly. Compound interest is very much like the final questions on the initial Who Wants to be a Millionaire? game show format, where large dollar amounts get doubled on the final questions.
A helpful tool to quickly do Rule of 72 calculations is the online MoneyChimp calculator. The calculator also includes simple estimates for other growth factors such as tripling or quadrupling a sum of money. The Power of 72 calculator from Northwestern Mutual is a useful resource to teach this concept to children.
Want to take small steps to build wealth over time? Save early and often and earn the highest investment return that you can consistent with your available funds and risk tolerance level. Use the Rule of 72 to make future savings estimates and to benchmark your progress over time.