Written by Sean Pollock

Monday, 16 June 2008 23:21

Would it be nice to see your money doubled? Sounds too good to be true? Not really. Every savings account, every money market account, any annuity has a potential to double your initial investment, if you keep it in for long enough. The question is how long should you wait to see your investment doubled? In general, how do you estimate the return on your long term investment? The first answer that comes to mind is to find the interest for the first year and multiply it by the number of years you expect to keep your account intact seems quite logical, but is not right. We just forgot to consider the power of compounding. Many people neglect this feature of investing. Yet, it is the compounding effect that makes long term investments so attractive.

Compounding simply means that after you received your first interest payment - and it could be as little as $1 - it will increase your interest payoff for the next cycle. Simply put, any interest payment becomes a part of your investment and immediately starts working for you.

Consider the following example: suppose you started from $1,000 in a savings account that fetches you a 3% interest every year. At the end of the first year, the $1,000 you have invested grows to $1,030; there is a net increase of $30 over your initial investment. At the end of the second year, the balance in your account would become $1,060.90. The net accretion in the second year is $30.90, that is $0.90 more than during the first year. This extra interest does not sound like a big deal for the second year. But in the third year you will get $31.83. This is how your interest grows larger year by year, and this is how you will double your money in about 24 years. Without compounding you would have to wait much longer: more than 33 years. Isn't it amazing how a little yearly increase in interest payoff cuts the time until the initial amount is doubled by almost 10 years?

Luckily there is a simple rule that helps you quickly figure out how long it would take for your investment to double. That method is called the Rule of 72. If you divide 72 by the interest rate that is being offered on an investment, you will know the time it takes in years to double your money. So how much better would it be if the savings account offered you a 4% interest rate - "just" 1% more. With the Rule of 72 we find that the time to double your money is 18 years. It is amazing that it cuts another 10 years to get your money doubled with such a modest interest rate increase.

Empowered by the rule of 72 you can appreciate the importance of getting the highest possible interest rate on your investment. The old saying goes "Time is money". The rule of 72 gives you a way to put a dollar value on time. Every single percentage point gain translates into sizable growth acceleration, and allows to reach your goals faster. Sometimes by decades.

Compounding can also work against you when we are talking about credit instead of investments. If you had a loan of $10,000 at 10% interest rate, which did not require you to pay anything for the first 7 years, by the end of 7 years you would owe almost twice as much: $20,000. A similar thing would happen if you keep a balance on your credit card for too long.

Rule of 72 is a simple and intuitive but very effective in understanding compounding and time value of money. Compounding is the magic behind creating wealth. Use the power compounding wisely, put it to work for you and don't let it work against you.