The power of compound interest & the rule of 72

Did you know Albert Einstein called compound interest the 8th wonder of the world? Basically, compound interest is “interest paid on interest”.

This concept is great when saving for the long-term, but it also works against you when borrowing or not paying what you owe.

With compound interest, you will pay more. Cable companies have a habit of charging monthly compound interest on outstanding invoices. A 2% per month balloons into 26.8% a year!

If you are saving, it can significantly boost your investments.

The formula to calculate compound interest is somewhat complicated -and boring-, but as an example, if you invest $1 000 at 5% compounded annually and don’t touch it for 5 years, your money will grow to $ 1 276.28.

With simple interest, you would only receive $ 1 250.00. Now, you can imagine what your money would earn you over an extended number of years with compound interest?

What impacts the amount is the rate but also the number of times it is compounded. A monthly compounding will earn you more than an annual one.

Another interesting concept is the rule of 72. It tells you the number of years it will take for your investment to double. Simply divide 72 by the interest rate.

See the examples below:

Rate of Return Rule of 72 Actual # of Years
2% 36.0 35
3% 24.0 23.45
5% 14.4 14.21
7% 10.3 10.24
9% 8.0 8.04
12% 6.0 6.12
25% 2.9 3.11

 

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