Friday, May 22, 2015

One Simple Rule That Non-Financial People Need to Know

We like to keep things as simple as possible.  And one of the most useful rules of thumb in finance, the 'Rule of 72', is exactly that.  It states that compound interest causes money to double when the number of years (Y) times the interest (I) equals 72. 

Pretty simple, right?  But pretty powerful as well.  We can use this Y x I = 72 formula to do some quick calculations to help take a look at what the future might hold or what has happened in the past.

For example, if you put away $10,000 for your daughters education and you invest it at 10%, in seven years it will be worth $20,000.  And then in 14 years it will be worth $40,000.  And it then follows that in 21 years it will be worth $80,000.

Or if you got a $15k inheritance from your avid outdoorsman uncle and want to set the money aside until you can afford to buy a $30k boat because that's something that would really honor him, how long will it be until you can afford it?  If you earn 10% it will take just over seven years (10I x 7.2Y = 72).  If you earn 12% it will take six years (12I x 6Y = 72). If you earn 4% it will take 18 years.

How about calculating how your old 401k has done?  When you left your old company a dozen years ago it was worth $60k, and now it's worth $100k...up more than 50% seems pretty good, but how well did you really do?  Since you had no contributions affecting the calculations, you can use the rule of 72 to estimate what kind of return you've gotten.  Since its been twelve years, and twelve goes into 72 six times, we know that if you had earned an average of 6% per year your money would now have doubled to $120k. It would take some more detailed calculations to figure out the exact rate you earned, but we know that it was something a little less than 6%.

You can also do some quick time value of money calculations.  If your parents bought their house for $55,000 in 1979 and we assume inflation of 4%, since 4I x 18Y = 72 we know that every 18 years the inflation-adjusted value would double.  So in 1997 dollars they paid $110,000, and in 2015 dollars they paid $220,000.

When you have financial decisions that require detailed calculations and expert advice, we can help.  But even people who cringe at the sight of interest rates, tax table and dollar signs can be quite financially proficient by just keeping the Rule of 72 handy.

1 comment:

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