Are you thinking of achieving financial independence, retire early (FIRE)? Whether you are or not, it literally pays to know the rule of 72 and use it.
To begin with, let’s get clear about what the rule of 72 is.
The Rule of 72 is a “formula that is used to estimate the number of years required to double the invested money at a given annual rate of return” (Investopedia).
So, using the rule of 72:
72 divided by interest rate = the number of years it takes your invested money to double.
The Pros of the Rule of 72
-It’s fast. It allows you to quickly calculate how long it takes for your money to double.
-It’s simple. Most folks are able to use this rule in their head to make a quick calculation.
BUT this rule is actually too simple to be of any practical use in the real world! Consider its shortcomings . . .
The Cons of the Rule of 72
–It doesn’t consider your costs like the amount of taxes you have to pay and the fees that you get charged to manage your investments. This will reduce your net income.
–It doesn’t consider inflation. Inflation erodes your purchasing power and makes your money “smaller”. Also, remember that the cost of necessities like food, rent, utilities and medical care keeps increasing at a rate higher than the overall inflation rate.
-It is not a precise calculation. It won’t give you exact numbers.
But the rule of 72 is still useful. Let’s look at some examples of how this rule can help us:
Example One :
There are certain high-yielding stocks that pay you 6% dividend.
A stock such as AT&T gives you 6.45% annual dividend at the time of writing. Wow 🙂
Say you have $2000. You want to know how much this money will double if the dividend or interest rate is 6%.
Using this rule, take 72 divided by 6. This gives you 12 years.
72 ➗ 6 = 12 years
So your $2000 will grow to $4000 in 12 years’ time (tax and inflation are not factored in here).
Say you have $10,000 and you want to know how long it will take to double, with an interest rate of 4%
How long will it take for your $10,000 to turn into $20,000?
Yep. You’re right. The answer is 18 years. 18 is the outcome of 72 divided by 4.
An important point to note is the rule of 72 assumes that whatever you earn is reinvested back into the principal sum.
The principal is the amount of money you invest, while interest is the money your principal earns you.
The rule of 72 shows how powerful compound interest is in making you richer.
Compound Interest Powers the Rule of 72
Compound interest is interest that is earned by your original principal sum PLUS interest that comes from your reinvested earnings.
Albert Einstein said: “compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
Remember his wise words! Harnessing the power of compound interest will move you closer to FIRE.
Understanding how the rule of 72 works is well and good. But the most important thing to note is for you to continue to be frugal. You need to persist in consistently saving more money. So that you can afford to continue to invest and reinvest more and more, and so become richer and richer.
It’s the time factor.
When you save, invest and reinvest consistently, you’ll achieve your FIRE or other goals sooner. Whether you’re saving for retirement or to buy a home.
But Inflation and Taxes are the Arch Enemies of FIRE and the Rule of 72
The US inflation rate at the start of 2019 stands at 1.55%
Inflation is one of the greatest threats to your FIRE financial well-being. How so?
If your dividend is 4%, and your tax rate is 10%, your net dividend is only 3.6% (the outcome of 4% X 90%). But that’s not all!
“Thanks” to the 1.55% inflation rate, your net gain is even less: 3.6 minus 1.55, leaving you with 2.05%.
2.05% is only about half of the 4%. Note that inflation takes away almost 4 times as much as your tax!
The Absolutely Accurate Way to use the Real Rule of 72
It’s actually much more realistic and accurate to calculate this way when applying the rule of 72:
Say you have saved $10,000.
Your $10,000, if it earns a gross 4% dividend, will double in . . . 35 years! What?? Sadly, it’s true:
72 ➗ 2.05 = 35.12 years
(The net dividend is really 2.05% after deducting the tax rate of 10% and the inflation rate of 1.55%, as explained earlier).
What can you do?!?!
How to Counter Taxation and Inflation, and Still Reach FIRE
To counter the double trouble – taxation and inflation – you must keep taking steps to:
-increase your income and keep increasing it
-save more and more
-invest better and more
-reinvest more to compound your interest growth.
When you do all these things, your financial future will become very secure indeed.
(Of course, you mustn’t turn into a mean scrooge – it’s important to reward yourself for reaching your money targets. For example, it’s fine to go on an affordable trip to reward yourself).
And if FIRE is your goal, you’ll reach it much sooner 🙂
Share this article with others, so that they’ll also benefit financially from knowing this information 🙂