Saturday, September 02, 2000
Compound interest doubles fun
Compound interest has been a favorite of world geniuses for centuries. Benjamin Franklin is quoted as saying it was the eighth wonder of the world. Then again, so is the legendary banker Baron de Rothschild.
Albert Einstein discoverer of the most earth-shattering physics and mathematical discoveries supposedly counted compound interest as the greatest.
Compounding is mankind's greatest invention because it allows for the reliable, systematic accumulation of wealth, Einstein supposedly said.
Forget natural law, the theory of relativity, the law of gravity. These guys were much more impressed with the Rule of 72.
Franklin is still remembered for his endless expositions on fiscal frugality. A penny saved is a penny earned is one of his, for example.
That saying, many believe, was actually a comment on compound interest. Franklin was saying that if you save one today, eventually you will have two. All thanks to interest.
It works this way: Let's say instead of a penny you save $100 (inflation, you know). If you earned 10 percent interest a year, you'd now have $110.
Under the rules of simple interest, the next year you'd earn another $10, for a total of $120. But under compound interest, your additional $10 also earns interest. Ten percent of $110 is $11, giving you a grand total of $121.
That extra one dollar isn't much now, but wait a few more years. After a little more than seven years of compound interest, you will double your money. It would take 10 years to double under simple interest.
How long until you double your investment with compound interest is easily figured with this hard-and-fast law of the universe: The Rule of 72.
This says that you divide your annual average return (like 10 percent above) into 72 to get the number of years it would take to double.
Conversely, you could divide the number of years you want to wait before doubling into 72 to find the average annual return you would need to achieve your goal.
You got a 12 percent average annual return? Your investment will double in six years. You want your money to double in only three years? You'll need a 24 percent average annual compounded return.
Maybe your blunder?
The Rule of 72 can work against you if you're not careful. In the above paragraph, replace the word investment with debt. If your outstanding loans capitalize unpaid interest, then you'd owe interest on your interest with your debt growing exponentially according to the Rule of 72.
Pay down debt so you don't owe double in a few years, and sock that money away in an interest-bearing investment where you can instead watch your investment double.
It doesn't take a genius to see the benefit of that.
Amy Higgins writes about personal finance for the Enquirer. You can reach her at firstname.lastname@example.org.
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