By Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, [email protected]
America Saves Week and Military Saves Week was held earlier this month, so now is a good time to discuss savings strategies with service members. One of the basic financial tools that I often teach in personal finance classes is the Rule of 72, which can be used to illustrate the impact of time and compound interest on the growth of a sum of money.
To quickly estimate how long it will take for a sum of money (any amount) to double, divide 72 by the expected interest rate that can be earned on a savings or investment product. Here’s an example: $2,000 placed in an IRA invested in a stock mutual fund would grow to $4,000 in nine years at an 8% average annual return (72 divided by 8). The Rule of 72 assumes that the interest rate stays the same for the life of an investment and that all earnings are reinvested.
Let’s look at 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 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 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. Contestants can only get the opportunity to double large dollar amounts if they progressed through the lower dollar amount questions that came first.
You can also use the Rule of 72 to estimate the interest rate required to double a sum of money. Divide the desired number of years desired to reach a financial goal into 72 to estimate the interest rate that is needed to achieve a financial goal on time. For example, if you want to double your money in ten years, you’ll need to earn 7.2% (72 divided by 10). To double money in eight years, you’ll need to earn 9%. The higher the interest rate, the faster money will double.
A third use of the Rule of 72 is to determine the effects of inflation over time. By dividing an assumed inflation rate, say 4%, you can see that the purchasing power of a dollar will be cut in half every 18 years (72 divided by 4). The Rule of 72 shows that, even with a relatively low rate of inflation, prices will rise and cut purchasing power significantly over time.
Sadly, it is not enough for service members to simply save their money. They also need to invest some of it. Going back to the Rule of 72, $2,000 placed in a certificate of deposit (CD) earning 1% will double to $4,000 in 72 years. Savings accounts earning one half of one percent will double in value in 144 years, which is longer than people live. For this reason, many financial advisors recommend “buckets” of retirement savings with some money invested in stocks.
A helpful tool to quickly do Rule of 72 calculations is the online MoneyChimp calculator at http://www.moneychimp.com/features/rule72.htm. The calculator also includes simple estimates for other growth factors such as tripling or quadrupling a sum of money.