Financial planning involves strategy. Basically, you need to plan how to get to where you want to go and how long it will take you to get there. If this involves retirement, planning should encompass both your current and your anticipated lifestyle. If this involves financing a child’s college education, planning involves setting aside sufficient funds in savings to pay tuition, books and living expenses when your child needs the money.
But, how do you calculate how long it will take to get to your goals? The easiest way is to use the “Rule of 72.” The Rule of 72 is a handy rule used in finance to estimate quickly the number of years it takes to double a sum of capital given an annual interest rate, or to estimate the annual interest rate it takes to double a sum of money over a given number of years.
Simply, dividing 72 by the rate of return on your investments equals the approximate number of years it will take for your money to double. Or, dividing 72 by the number of years you have until you need to use the money you have set aside equals the rate of return you need to have on your investments.
For example, David and Susan have saved $10,000 towards their six-year-old child’s college education. They want to know how long it will take them to double that amount. Their daughter is now age six, so assume she will need the money to go to college when she is 18. That’s 12 years of saving, so 72 divided by 12 equals a 6% rate of return on their investments. In other words, David and Susan need to obtain a six percent rate of return on their investments for 12 years to double their savings to $20,000. That means no spending from the college account and reinvestment of all dividends and interest for the period of 12 years.
The Rule of 72 can also be used to calculate the effect of inflation. If college tuition increases at 5% per year, tuition costs will double in 72 divided by 5 or about 14.4 years. Think about it. That means David and Susan need to save much more money for college than they might at first have anticipated.
The Rule of 72 is a simple math shortcut to estimate the effect of any growth rate. The formula is “years to double equals 72 divided by interest rate.” The results you achieve, a doubling of growth shows you the tremendous effect of compounding interest.
What is compound interest? For example, start with $1 at 10% interest. At the end of one year you have $1.10 and at the end of year two you have $1.21. The dime earned in the first year starts earning money on its own (a penny). Next year add another dime that starts making pennies, along with the small amount the first penny contributes. Ben Franklin, said by some to be the inventor of the Rule of 72, apparently said: “The money that money earns, earns money.”
Compound interest is deceptively small, cumulative growth that is very powerful. No wonder that Einstein is reputed to have called it one of the most powerful forces in the universe.
Don’t let the rule of 72 work against you, as it does when you take on high interest debt. At an average interest rate of 18%, the credit card debt doubles in just four years (18 X 4 = 72), quadruples in only eight years, and keeps escalating with time. The first rule of your financial plan should be to pay off all high interest credit card debt and avoid it like the plague.
Using the Rule of 72 will help you figure out what you need and for how long. Compound interest will be the way you get there. These simple concepts provide the basics of financial planning. Let the Rule of 72 work for you by starting saving now. At a growth rate of 8% per annum, you would double your money in nine years (8 X 9 = 72), quadruple your money in 18 years and have 16 times your money in 36 years.
No wonder financial planners advise 20-year olds to start a savings plan. Over time, with compound interest, even a small amount of savings consistently set aside when you are in your twenties could make you a millionaire by the time you are retired. But, even if you are older, compound interest works for you and you are never too young or too old to save.