Tuesday , 17 September 2019

# The Rule Of 72 Can Help You Reach Financial Goals – Here’s Why & How

Compounding can be tricky to calculate in your head, however, unless you’re a math whiz. The good news is you can use a mathematical shortcut called the “rule of 72” to quickly estimate how long it takes an investment with a fixed annual return to double in size.

###### The article below is an enhanced version (i.e. not a duplicate) of the original from MotifInvesting.com as it has been edited ([ ]) and abridged (…) by munKNEE.com to provide a faster and easier read. Enjoy!

The Perks of Compounding

First, it is important to grasp the concept of compounding. In essence, compounding refers to generating earnings from previous earnings. As an investment grows, the rate of return is calculated on a larger base. The opposite occurs if an investment is in decline.

For example, let’s say you invest \$10,000 in a stock that rises in price by 10% in year one. In other words, your \$10,000 grows to \$11,000 at the end of the first year. Happy with a \$1,000 gain, you decide to keep the investment. The stock rises another 10% in year two. At the end of the second year your total investment is now worth \$12,100. Even though the stock rises 10% in both years, your investment appreciates an additional \$100 in year two. Why? Your year two returns are calculated on a larger base, \$11,000 versus \$10,000.

Compounding can be tricky to calculate in your head, however, unless you’re a math whiz. The good news is you can use a mathematical shortcut called the “rule of 72” to quickly estimate how long it takes an investment with a fixed annual return to double in size.

Rule of 72: divide the number 72 by the annual rate of return you expect on an investment. The result is the approximate number of years it takes to double your money.

Now let’s see why it can take 10 years to double your money in stocks versus 72 years in a savings account. If you invest \$10,000 and earn a respectable 7% a year, it takes about 10 years to get to \$20,000.

72 / 7 = 10.28 years

Savings accounts and CDs, on the other hand, still earn close to bupkis these days. A savings account offered by a national bank currently yields 0.75% while a 12-month CD yields 1.05% Depositing \$10,000 with, say, a 1% rate of return – which is below the Fed’s target rate of 2% inflation – takes about 72 years to double. Wow, that’s a mighty long time compared to 10 years for stocks to double!

72 / 1 = 72 years

Of course the stock market does not provide a fixed rate of return every year. Use the rule of 72 for ballpark estimates. Your actual results can vary but historically stocks have been a more efficient way to grow wealth.

### Estimate Large Expenses With the Rule of 72

To help you plan for your future expenses, you can also use the rule of 72 to estimate them. Let’s say you welcome a baby into your clan. How much is her college education going to cost?

First, research shows the projected annual increase in college tuition and fees is 3-4%. Now use the rule of 72 to estimate how long it may take for tuition costs to double.

At an annual cost increase of 3%, tuition costs can double in 24 years.

72 / 3 = 24 years

If prices go up 4% a year, however, tuition can double in 18 years.

72 / 4 = 18 years

Let’s assume a 4% annual cost increase in our example since a baby born today should be ready to enter college 18 years from now.

Second, let’s examine the cost of college today. According to The College Board, in-state costs average \$9,410 for tuition and fees, and \$10,138 for room and board totaling \$19,548 for 2015-16. Private, not-for-profit schools average \$32,405 for tuition and fees, and \$11,516 for room and board totaling \$43,921. Public school expenses for out-of-state students fall in between.

Let’s use an initial cost of \$32,000 per year. Applying a subsequent 4% increase in cost each year results in an approximate cost of \$135,886 for a student entering a 4-year college today.

Year 1: \$32,000
Year 2: \$33,280
Year 3: \$34,611
Year 4: \$35,995

Total: \$135,886

Lastly, double the above total to get a rough idea of how much your baby’s college education expenses will be in 18 years: \$271,772. That’s quite a difference!