The Rule of 72 is a simple mathematical principle that anyone who is investing wealth or owes money should know intimately. Every parent should teach it to his or her children, and every teacher should teach it to his or her students. If you understand the Rule of 72, you’re qualified to answer almost any question that comes your way about how you should handle money, and if you get it, you’ll be smarter than 80% of those around you.
The Rule of 72 is all about doubling your money. Divide your effective rate of return into 72. The result is the number of years it will take for your money to double. So let’s say you’re getting 3.5% interest after tax on a passbook savings account. 72 divided by 3.5 is 20.6, so it would take 20.6 years for the money you have invested in that passbook savings account to double. Not very exciting, huh?
Now let’s say instead that you invest instead in a good mutual fund that, historically, has produced an average return (after your expectation about the tax you will pay) of 10%. Divide 72 by that 10%, and now you’re looking for your money to double in 7.2 years. Yes, there’s always a chance your investment might decline in value. but you may live with a higher level of risk if it means a high probability of greater success.
If you look at the short term, it always seems safer to put money in that savings account. But if you can step back and look at the long term, the Rule of 72 brings things into focus. Let’s put some life in this example by investing some real money. Let’s say you’re 20 years old and you have $10,000 in cash. What should you do with it? Should you spend it? Invest it in that savings account? Invest it in a mutual fund? Let’s look.
Notice how little the difference seems to be during the first few years. It’s not until age 50 that we all can see how dramatically the Rule of 72 works. But by age 70, can you see what difference it makes? The Rule of 72 encourages us to think long term.
Now think about this. Would you rather have $10,000 at age 20 or $150,000 at age 50? Actually, you already know, because you understand the Rule of 72. Assuming you can invest 10% after tax on average, you’ll take the money at age 20 and turn it into $174,000 by age 50. But that depends on your having the discipline to invest it and not spend it. The Rule of 72 encourages us to invest early and leave it alone.
Think the Rule of 72 only works if you have money to invest? Not so fast. It works on your debts too. If you borrow $10,000 at age 20, and if you (theoretically) made no payments on the debt, you can divide your after-tax interest rate into 72 to determine how fast your debt will double, leaving you further in the hole financially. The more you borrow, the more the Rule of 72 works against you. The less you pay on your debt, the more the Rule of 72 works against you. The Rule of 72 encourages us to borrow as little as possible at as low a rate as possible and to pay back as much as possible as soon as possible.