Before making any investment decision, one of the key elements you face is working out the real rate of return on your investment. Many of us have heard about simple and compound interest, but what's the difference anyway?
With simple interest, interest is paid just solely on the principal. With compound interest, the return that you receive on your initial investment is automatically reinvested. In other words, you receive interest on the interest.
So just how quickly does your money grow? The easiest way to work that out is by using what's known as the "Rule of 72."1 Quite simply, the "Rule of 72" enables you to determine how long it will take for the money you've invested on a compound interest basis to double. How it works is you divide 72 by the interest rate to get the answer.
For example, if you invest $10,000 at 10 percent compound interest, then the "Rule of 72" states that in 7.2 years you will have $20,000. You divide 72 by 10 percent to get the time it takes for your money to double. The "Rule of 72" is a rule of thumb that gives approximate results. It is most accurate for hypothetical rates between 5 and 20 percent.
While compound interest is a great ally to an investor, inflation is one of the greatest enemies. The "Rule of 72" can also highlight the damage that inflation can do to your money. Let's say you decide not to invest your $10,000 but hide it under your mattress instead. Assuming an inflation rate of 3.5 percent, in 20 years your $10,000 will have lost half of its value, or have about the same buying power as $5000 has today.
The "Rule of 72" is a quick and easy way to determine the value of compound interest over time. By taking the real rate of return into consideration (nominal interest less inflation), you can see how soon a particular investment can double the value of your money.
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