This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.
The Rule of 72
Now that you have a better understanding of where to put your money and when, you may be asking “Why?” After all, you’re a smart college graduate and you want to actually understand why money works this way, you’re not content just letting me tell you what to do with it, right? To simplify everything, it really boils down to the rule of 72.
The rule of 72 is a simplified way to discuss compound interest. When you put your money in a bank, for instance, you may earn about 3 percent interest (plus or minus, depending on the economy). If you put $100 in the bank at 3 percent interest, you can expect to have $103 in your account after one year. Big deal. But let’s say you leave that $103 in the bank. The next year you will have $106.09. You earned interest on your interest! You earned 3 percent on the $3 interest you left sitting in your account. The extra nine cents may not seem like much now, but after 24 years, you will have about $200 in your account. That’s right, you will have doubled your money in about 24 years. What if the interest did not compound? You would only earn $3 interest per year and it would take 33 years to double you money. You doubled your money nine years sooner just because of 3 percent that was compounding. What if it was 6 percent or 12 percent?
Run your own analysis with our compound interest calculator.
The rule of 72 says that if you divide the number 72 by the interest rate, the result is how many years it will take to double your money. Seventy-two divided by three is 24. It will take 24 years to double your money at 3 percent. Seventy-two divided by 12 is only six. If you were investing and earning 12 percent per year, it would only take you six years to double your money. This simple rule explains why the amount of interest we earn is so important.
Let’s look at a few examples. Larry, Carrie and Mary are triplets who were each given $1,000 from their parents for Christmas on their 25th birthday. Larry puts his money in the bank and earns 3 percent interest. Carrie buys some corporate bonds and earns 6 percent interest. Meanwhile, Mary invests her money in the stock market and earns a 12 percent return annually. Forty years later, when the three are ready to retire, they check to see how much money they have. Larry is disappointed when he sees that he only has $3,315. Carrie is happy to see that she has $10,957 waiting for her after selling her corporate bonds. Meanwhile, Mary is able to do all the traveling she wants in her retirement with the $118,648 she has earned from the stock market!
From the above example you can see that the interest rate makes all the difference in the world. Three people had the same amount of money to invest, and kept it invested and compounding for the same amount of time, but Mary, who was earning 12 percent ended up with more than 35 times the amount that Larry had earned! By the way, Carrie was no longer happy with her $11,000
The power of compounding works best when combined with the power of time. You see, if the three of them would have checked their balances after 12 years, Larry would have about $1,433, Carrie would have about $2,051 and Mary would have about $4,191. There is still a significant difference between the three, but not as much as there was after 40 years. That is why you need to start thinking about your retirement now. Look at Figure 11-3 to see how compounding works over time.
What you should see in Figure 11-3 is that in the beginning, compounding creates a little bit of upward momentum during the first several years (through year 11). Then, the pace seems to pick up a little more (years 12 through 25), and then it really picks up the pace (years 26 to 33). Finally, look at how quickly the investment grows towards the end of this 40-year picture (years 34 to 40). Remember, this is just a one-time investment of $1,000 earning 12 percent interest per year. This example assumes no more money was added.
To get an even better picture of how compounding works, let’s say the three siblings from the above example decided to save an additional $1,000 each year until age 65. After 40 years, Larry would have about $80,000, which is not bad, considering he only had to contribute a total of $40,000. Carrie would have about $175,000, which is really good considering she also contributed the same amount, $40,000, over her working career. Mary, if you can believe it, would have over $1 million. That’s right, she would have over $1 million and she only had to save a total of $40,000 over her working career. Mary is on her way to a very comfortable retirement.
Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.com or www.TheGraduatesGuide.com.