Rule of 72 refers to a formula that can help individuals quickly measure the time it will take to double an investment amount at a certain interest rate. They can also estimate the rate of interest for a certain instrument of investment if they know how many years it will take to double the amount.
Although this formula makes a rough estimation and not a completely accurate one, people use it as they can make the calculation mentally. Individuals will not have to use the calculator or a spreadsheet.
Formula for Rule of 72
Using two formulas mentioned below individuals will be able to approximately calculate the number of years or rate of interest it needs to double an investable corpus:
Formula to measure the number of years to double a certain amount is:
Years = 72 / rate of interest
Individuals will have to divide 72 by the given interest rate to know how many years they will have to wait for four doubling their money.
Let us assume that the annual interest rate of a fixed deposit is 10%. Individuals can use this formula as mentioned below to know after how many years their fund will become double:
Years = 72 / 10 = 7.2
Formula to measure the interest rate that can double a certain investment amount is:
Interest rate = 72 / number of years to double a certain amount
Individuals will have to divide 72 by the time frame when a certain amount of funds will be doubled. With rule of 72 calculator, they will be able to estimate the interest rate given on their instruments of investment without even taking resort to the magic of a compounding calculator.Let us assume that the invested sum will become 200% after 8 years at a certain annual compound interest rate. Individuals can understand the interest by doing the following mental mathematics:
Rate of interest = (72 / 8)% = 9%
How rule of 72 works?
In the formula of rule of 72, there are two variables. These are the interest rate and number of years. Individuals, therefore, need to know either of those variables to approximately calculate the other. For this, they will simply need to divide 72 with the given input.
However, results generated by using this rule of 72 are not completely accurate but very close to the precise result for interest rates ranging from 6% to 10%. Following is the delineation of how close the result generated by this formula is:
Let us assume that the interest rate of an FD is 7.0%. Years needed to double the valuation, as generated using the rule of 72 formula will be (72 / 7) years = 10.28 years. The actual years to double the valuation are 10.24 years, given the interest does not change. So, there is only a difference of 0.04 years between these results, making the Rule of 72 a fairly accurate formula for estimation.
Different uses of the Rule of 72
Individuals can use this rule of 72 for any calculation that involves compounded growth. For example, they can apply this formula in mutual funds, fixed deposit value, charges, GDP growth, etc., given that the interest rate remains unchanged. For example, if you expect that a certain fund will increase at a constant compound interest rate of 8%, its valuation will double within a time frame of (72/8) years or 9 years.
Advantages and Disadvantages of Rule of 72
The following are the benefits and drawbacks of the Rule of 72:
Advantages:
- It is a simple strategy that can be employed immediately by any investment.
- It enables investors to calculate the time required to double their capital.
- Investors can modify their risk exposure and positions as needed.
- It provides investors with a defined time horizon for when they can sell their investment holdings for double the profit.
- It can be used to any market factor, such as GDP, population rate, etc., as long as an annual rate of interest is estimated.
Disadvantages:
- The Rule of 72 is primarily accurate for lesser returns of 6-10%. The projected value for anything higher can fluctuate.
- It is not an exact value and can only provide a general estimate of the time required to double the investment.
- If the interest rate changes due to some factor, the Rule of 72 becomes null and void.
- The Rule of 72 does not apply to changing interest rate investments or basic interest investments.
What is the difference between rule of 72 and Rule of 70?
The rule of 72 says that individuals will have to divide 72 by the number of years or rate of interest rate. It can give you close to accurate results when the interest accrues annually.
On the other hand, according to rule of 70, individuals need to use the number 70 in place of 72. This rule can fetch the approximated results if the frequency of accruing interest is semi-annual.
How to know the impact of inflation on money using Rule of 72?
With inflation, the relative value or the purchasing power of currency decreases. It is a general rule of money that individuals need to keep in mind while investing with the objective to grow their funds.
Individuals also need to know what time it will take to reduce the relative value of money to half at a certain inflation rate. For this, they will have to divide 72 by the inflation rate. For example, if the current inflation rate is 6%, it will take nearly 12 years to reduce the value of a currency to half, given that the inflation rate remains the same.
Rule of 72 lets individuals make a close estimation regarding the time it needs to double the value of an object or a fund at a certain compound interest rate. Also, if they know that a fund will double after certain years, they can also get a rough idea about the compound interest rate using this formula. One of the major benefits is that they can make all these estimations mentally without the help of any calculator.
