What Is Compound Interest and The Rule Of 72?

If you are serious about learning how to get rich, then you must understand the importance of generating compound interest. Compound interest is one of the best ways to generate additional passive income and multiply your money for free. Albert Einstein once said, “compound interest is the 8thwonder of the world. He who understands it earns it, he who doesn’t pays it.” Compounding your interest can make the difference between receiving ordinary returns and achieving super sized returns on your money. Understanding how compound interest works and the mysterious Rule of 72 will help you to double your money faster and eliminate your most dangerous debts.

What Is Simple Interest?

In order to understand the Rule of 72, you must first understand the difference between simple interest and compound interest. Simple interest is the profit earned on any amount of money lent over a single period of time. It is the amount of interest earned on the original amount of money (principal) invested. It is defined by this formula: 

Interest = Principal x Rate x Time

  • Principal equals the original amount invested.
  • Rate equals the interest rate paid for the use of money lent.
  • Time equals the period or length in which the interest is earned.

Multiply those three variables together and you receive the amount of interest earned.

Simple interest is interest that earned on the principal only. For example, let’s say you invest $10,000 and earn a 9 percent annual return for 10 years. The simple interest earned over 10 years would be $9,000. Your total investment would be worth $19,000 after 10 years based on simple interest. You are earning the same amount in interest payments each year with no variance. Investments like corporate bonds pay simple interest on a semiannual basis. You earn the exact same amount of interest every six months based on the face value of the bond. The interest payments are fixed and never change over the life of the bond.

What Is Compound Interest?

Compound interest however is a totally different ballgame. Compound interest is interest earned on top of interest. It’s the interest computed on top of the principal plus interest earned. You earn interest returns on top of the regular returns. Compound interest can be compounded daily, monthly, semiannually or yearly. Daily compounding calculates and accrues interest each day. Monthly compounding calculates and accrues interest each month. Semiannual compounding calculates and pays interest every six month. Annual compounding calculates and pays interest every year. Here is the formula for compound interest.

A = P (1 + r/n) (nt)

  • A = Amount of Money Accumulated 
  • P = Principal
  • N = Number of Compounded Periods
  • T = Time

Let’s take the same $10,000 investment with the same 9 percent interest rate for 10 years but this time factor in compound interest.

Quarterly compound interest Ex: A = 10000(1 + 0.09/4) 4(10

Principal         Rate            Years       Compounding Frequency              Future Value
$10,000         9 %            10 years         Compounded Yearly                   $23,673.64
$10,000         9 %            10 years         Compounded Semiannually     $24,117.14
$10,000         9 %            10 years         Compounded Monthly               $24,513.57
$10,000         9 %            10 years         Compounded Daily                      $24,593.30

As you can see, the more frequently that interest is compounded, the greater the future value of your investment. Daily compounding reaps the greatest return on investment while yearly compounding reaps the lowest ROI. Compound interest causes your money to grow at a faster rate than simple interest can achieve. All of the compounded returns displayed above exceed the $19,000 value earned using simple interest. Another famous quote attributed to Einstein states, “the strongest force in the universe is compound interest.” 

What Is The Rule Of 72?

The Rule of 72 is simply a formula for computing compound interest.  The Rule of 72 is an easy way of calculating how long it will take before the value of your money doubles. You take the number 72 and divide it into the annual rate of return on your investment. It works like this. Let’s say you invested $10,000 in a mutual fund and received a 9 percent annual rate of return. How long would it take before your investment doubled? You just divide 72 into 9(annual rate of return), which gives you 8. This tells you that your $10,000 investment will be worth approximately $20,000 in 8 years.  Your initial investment will double in 8 years (72/9). Once again, you can see the power of compounding. The same $10,000 investment at 9 percent simple interest is only worth $19,000 after 10 years versus $20,000 in just 8 years with compounded interest. That’s an extra $1,000 in interest earned in 2 fewer years.

Investors use the rule of 72 to determine how long an investment in a mutual fund, stock, or property will take to double their money. It’s important to not that the Rule of 72 is not an exact financial measurement but a pretty close guesstimate. (*The actual value of a $10,000 investment after 8 years at 9 percent interest is $19,925.63, which is a little shy of $20,000. An interesting fact is that dividing by the number 70 works just as well and often times provides a more accurate measurement of doubling your money than 72.) Use the Rule of 72 whenever you are quickly trying to get a time frame for how long it will take you to double your money. Anytime I am trying to figure out how to multiply my money quickly, I use the Rule of 72. For in depth financial analysis, I still rely on a financial calculator.

How Can I Earn Compound Interest?

Compound interest is a powerful tool and can either work for you or against you.

Compound interest works against you when you borrow money in the form of auto loans, credit card debt, home loans, student loans, and all types of debt repayment. Most debts and financial obligations tend to compound interest daily since creditors seek to maximize the amount of interest that you are forced to repay. This increases the total amount of interest that you have to repay keeping you in debt for a longer period of time. That is why it is imperative that you prioritize paying down the debts that compound interest the most frequently. You will save yourself a lot of cash in the long run.

Compound interest works for you when investing in assets like money market mutual funds, certificates of deposit, money market accounts and savings accounts. Compound interest accelerates your interest income allowing your investment to appreciate faster than simple interest enabling you to build wealth faster. Place your money in banks that compound interest daily to get the maximum return on your savings and money market accounts. Banks like Capital One and Bank of America compound interest daily whereas Chase Bank compounds interest monthly meaning you would earn more interest on an account at BOA and Capital One if interest rates are the same. Follow the example of the rich by understanding the power of compound interest and use it as a money multiplying force!

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