Calculating an interest and that too compounded is a tedious work to do. And it is more difficult to estimate the length of time required to double an investment. And without proper calculation, no investment can be done. Here is FinanceShed with a complete understanding of Rule of 72.
The Rule of 72
Basically, rule of 72 is nothing but a formula that estimates the time investment takes to double its value at a given fixed annual rate of return. The rule of 72 is a shortcut calculation to determine the amount of time for a long term investment to double in value by taking the number 72 and dividing it by the interest rate. These rules apply to growth and are therefore used for compounding interests as opposed to simple interest calculations.
How to calculate Rule of 72?
Years to double = 72 / Interest Rate
If you want to find the number of years your long term investment is going to take to double itself, you have to divide 72 with the interest rate. Also one should always bear in mind that the rate of interest should be fixed in order to get a perfect answer from this formula. The rule gives a perfect answer as long as the rate of interest is less than 20, as the rate increases the error also increases. You can always find the missing value by putting the available values at the specified places.
Where rule of 72 is used?
The rule gives perfect results when the interest rate is nearly 8%, as and when the rate decreases or increases to a greater extent the errors will increase and the estimate becomes less accurate. This, we can say, is a disadvantage of the rule of 72. Another disadvantage of the rule is the inaccuracy when a large amount of money is involved. Basically, it doesn’t affect much the outcome but the company or individual may choose to use the actual doubling time formula as each decision could affect their profitability on a larger scale. The choice of 72 as a numerator is also backed with some great logic and is chosen because it has many small divisors such as 1, 2, 3, 4, 6, 8, 9, and 12. It provides a good approximation for annual compounding, and for compounding at some pre-determined typical rate of interest. The rule of 72 can also be used for expenses like inflation or interest and can be helpful for approximation such as if the inflation rate increases the value of money will decline to the specific level. Many investors use the rule of 69.3 rather than the Rule of 72 for a higher level of accuracy. Rule of 72, which was derived before the 14th century, is relatively very simple while calculating and quick for calculation for the effects of compounding rates of interest. This rule can also be used by previously deciding the return expected and then choosing the interest rate.