The Rule of 72
“Compound interest is the eighth
wonder of the world. He who understands it, earns it â€¦ he who doesnâ€™t â€¦ pays
it.â€ â€“ attributed to Albert Einstein and many others
In 1956, 26-year-old investing legend Warren Buffett returned to his
hometown ofOmaha from New York to start an investment fund. He went door
to door, calling on his fatherâ€™s friends. Seeing his threadbare suit and shirt
frayed at the cuffs, prospects despaired. But they had watched young Warren
grow up, so they listened politely. Buffett began by explaining the Rule of 72.
What? He didnâ€™t deploy arcane financial jargon, boast of his New York
experience or regale with promises of wealth. Instead, he started with a math
concept requiring only division. And those who listened and invested became the
now-famous Omaha Buffett Millionaires.
Message? To grow wealth, start with the Rule of 72. Hereâ€™s how it works.
If I hand someone $1,000 and ask how long it takes to double if invested at
10% annual interest, most people answer, “ten years.â€ Right?
Not at all. Itâ€™s not 10 years, but 7.2 years. At 5% interest, not 20 years,
but 14.4. Divide 72 by an interest rate to know how many years it takes money
to double at that rate. Or, divide 72 by the number of years in which you want
to double money to learn what interest rate you will need. At 9%, your $1,000
doubles in 8 years (72 divided by 9). To double money in 12 years, 6% annual
interest is required (72 divided by 12).
How can this be? Compound interest. (See, Einstein.) Your money earns 10% in
year one, thatâ€™s $1,100. Then, 10% on the $1,100 is $110, giving you $1,210 at
the end of year two. After three years, $1,331, four $1,461, then $1,611,
$1,772, and $1,949, with the rest coming in 0.2 years for $2,000. Your money
has doubled in 7.2 years, hence the Rule of 72.
It gets better. The $2,000 takes another 7.2 years to double, but the
original $1,000 triples to $3,000 during the 12th year, $4,000 in the 15th,
5,000 in the 17th and keeps on accelerating. Your money is wet snow rolling
down a hill. The longer the hill, the larger the snowball, the more your money
grows. Donâ€™t wait.
However, itâ€™s not always roses: “He who understands it, earns it,â€ but also
“He who doesnâ€™t, pays it.â€ Say we charge $100 on a 12% interest credit card. If
we never make a payment, our debt doubles in six years. In the real world a
minimum payment is required, though interest eats up most of it. The point
remains: Compounding rewards the saver and shackles the debtor.
So donâ€™t wait to pay off your high interest debt and find a dollar, wet
snow, and a hill. Begin your journey to financial independence now.