The Magic of Compound Interest

The Rule of 72 is an amazing tool for calculating the results of compound interest on an investment. It makes it easy to demonstrate what many people have called the magic of compound interest.

The Famous Rule of 72

Several years ago an investment firm became quite prominent, at least for a while, by utilizing a two step sales pitch that had a very powerful impact.

First, they showed how much money the average person lost on their insurance policy by buying whole life or universal insurance instead of term. Most people were unaware at the time, it seems, of how little return they got for the so called investment part of their policy and how much it was costing them.

Second, they showed the remarkable investment returns possible by investing in mutual funds as a result of switching from whole life to term insurance and then investing the difference. To do this they introduced people to, and through word of mouth helped make famous, the Rule of 72 which is now a well known bit of financial information.

The Rule of 72 and Compound Interest

In case you are not familiar with it, we will explain it here. The Rule of 72 is nothing more than a formula that projects how long it will take to double your money at any given interest rate. Or, in reverse, for a given period of time, what interest rate would be required to double your money.

For example, for ten percent interest, just divide ten into 72 and you see that in just over seven years (7.2) your money would double. Or, for your money to double in ten years, ten divided into 72 tells you you need 7.2% interest.

An important application is to look at long term investing in the stock market. It has produced a little over 11% growth over its history There are short term losses, of course (we are in the midst of one now with our economic crisis!), but even going through a depression it is just a matter of time for recovery to right the averages.

So dividing eleven into 72 projects that money doubles in approximately 6.5 years when invested in a whole market or Standard and Poors index fund (remember the disclaimer that past performance is no guarantee…).

Now let’s look at the long range projection. I will make a chart to show how compound interest goes with a single $1,000.00 investment.

Single Investment of $1,000 Over Time
at 11% Growth
Years Amount
6.5 $2,000.00
13 $4,000.00
19.5 $8,000.00
26 $16,000.00
32.5 $32,000.00
39 $64,000.00
45.5 $128,000.00
52 $256,000.00
58.5 $512000.00
65.5 $1,024,000.00

Lessons from the Rule of 72

The magic of compound interest truly is amazing when you look at this chart carefully as projected with the Rule of 72. Just seeing how much a one time investment of no more than $1,000 can become is breathtaking, even if the period of time is 65 years.

But the biggest impact it makes for me is when I think about the fact that while the first 6.5 years produced only $1,000, the last 6.5 years produces $512,000. The same period of years. No additional investments. No more work (none in either case).

There are two extremely important points to be emphasized above all others in my opinion. One is the incredible potential of investing, far more than labor or business. And the second is the absolute necessity to think long term for the greatest financial success.

Keep the Rule of 72 in Your Tool Box

The magic effect of compound interest becomes much clearer in our thinking once we use the Rule of 72 to project its impact. Keep it handy.