While I was in college, a friend and fellow colleague of mine told me about an interview that he had with Merrill Lynch. One of the questions that he was asked about was whether he knew about the Rule of 72. He knew about the rule and was able to answer their question satisfactorily. Because I did not know about the rule, I asked him to tell me more about it.
The rule shows how long it will take an investment to double if there is a fixed rate of return. By dividing 72 by the fixed rate of return, then one can approximate how long their initial investment will double.
For example, assume that the rate of return on an investment is nine percent and the initial investment is $1,000. The Rule of 72 states that 72 divided by 9 would take 8 years for the initial investment to double to $2,000.
Now assume that $1,000 is being invested into a project that gives a three percent rate of return. Under the Rule of 72, 72 is divided by 3 and the result is that it would take 24 years for the investment to double to $2,000.
Because one has a limited lifetime, the Rule of 72 dictates that one invests in projects that yield a higher rate of return. It is easier to double one’s money when the rate of return is 25% as opposed to three percent. The tradeoff to that is that one will likely assume more risk.
Another one of the interesting aspects of the rule is that it can also be applied to creditors. Simply substitute the APR on your credit card, mortgage, student loan, or car loan and divide it into 72 and the result will show you how long it will take you to double your creditor’s money. The higher the interest rate, then the more you will owe your creditors.
The incentive should encourage people to look for alternatives to lowering their interest rate to their creditors. One option could be refinancing a car loan or a mortgage to a lower interest rate. One can also seek a balance transfer to a credit card that has a lower APR. By lowering the interest rate, the less interest one will pay over time to their creditors.