The rule of 72 definition is an approximation tool used to determine the amount of time it will take for money to double on the earnings of compound interest. The Rule of 72 is also used to calculate the rate of return necessary to double an investment in a specific amount of years.
The rule of 72 is essentially an estimation for determining the amount of years or the doubling time of an investment. This is done by taking the interest available on the investment and dividing it by 72. Rule of 72 investing is usually fairly accurate. It is even more accurate with lower interest rates than it is for higher ones. Use he rule of 72 for compound interest situations. If the investment earns a simple interest at the end of the investment term, then this rule is not a very good indicator. The rule of 72 is most useful if an investor cannot perform an exponential function and simply needs to do simple math for an estimate of an investment.
A lower compound interest rate means that the investment will take longer to double. Whereas, a higher interest rate means that the investment will be doubled quicker. Thus, a higher interest rate and a lower doubling time are necessary for an investment to grow faster. Usually, a riskier investment will yield a higher interest rate and a higher return in less time. If you are planning on saving or investing your funds, then it is important for you to compare different interest rates so that you can maximize the value of your investment in the shortest amount of time. Since the rate of returns for investments vary with time, use the Rule of 72 as a quick tool. But do not use it as a full solution for analyzing the future value of investments.
The rule of 72 formula is as follows:
Doubling Time (# years) = 72/Interest Rate
What is the doubling time for an investment with a compound interest rate of 8%? A person using the rule of 72 equation would find the doubling time equal to 9 years. Calculate this by taking 72 and dividing it by 8. By performing this the investor can tell that it will take approximately 9 years to double the principal. It is fairly accurate as the exponential function yields an actual doubling time of 9.006 years. If you want to calculate the interest rate necessary to double your funds for a specific number of years, then divide 72 by the doubling time (# years).