Understanding how to calculate compound interest is at the heart of financial basics. Ever wonder how long it will take your 401(k) to double given a specific rate of return? Or what rate of return you would need to achieve for your investment to double in 5 years? Compounding can be basically illustrated by the “Rule of 72”. The Rule of 72 is a handy tool that can be used to approximate the amount of time it will take for your money to double.
Let’s say your 401(k) is earning 6.0% per year. Using the Rule of 72, it will take 12 years to double. That is, 72 divided by 6 equals 12. Similarly, an investment of $1,000 will double to $2,000 in 8 years if it grows at 9.0% per year. A savings account earning 0.5% will double in 144 years. Yikes!
This concept also works beyond investments. If the U.S. GDP can grow at 4.0%, then the economy will double in 18 years; however, it will take the U.S. economy 36 years to double if it grows at 2.0%.
Understanding how compound interest works highlights how small changes in interest rates can greatly impact how long it will take to double your money. In the example above, the difference between 2.0% and 4.0% translates to an 18-year difference in how long it takes for an economy to double. It starts to make sense that politicians spend so much time talking about how the economy is growing. To drive home the concept further, an economy growing at 4.0% will have doubled twice in the same time period it took the economy growing at 2.0% to double.
A company’s bottom line that grows at 10% will see earnings double in 7.2 years; when a company’s earnings increase at 5%, its profit takes 14.4 years to double.
The second example makes it clear why one would be willing to pay more on a price-to-earnings basis for faster-growing companies. This concept also illustrates why technology companies with strong balance sheets and high earnings growth rates trade at higher profit multiples than more steady, slower-growth utility businesses.
Hopefully this concept highlights the importance of compounding. Compounding favors those who start early – saving in your 20’s gives those monies time to double potentially 3 or 4 times before retirement. Said another way, $1,000 invested at age 20, earning 7.2%, increases to $2,000 by age 30. Maybe this doesn’t seem all that special. But follow that investment a few decades further, assuming the same rate of return, that $2,000 increases to $4,000 by 40, $8,000 by 50 and $16,000 by 60. There is a reason Albert Einstein is credited with saying, “compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
Who wants to argue with that?
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