Compound Interest and the Rule of 72

Piggy banks

What is compound interest?

Albert Einstein is said to have called compound interest the most powerful force in the universe. Whether he actually did or not is a matter of debate but it is undeniable that compound interest is a powerful tool in growing your savings over time.

Compound interest is a simple concept and refers to the return you receive from re-investing any interest earned from an investment such as a savings account or GIC rather than having it paid out. This adds the interest to your original investment principal, resulting in more interest being earned since you now have a higher amount invested. Compound interest is essentially interest earned on interest.

The example below illustrates how an initial investment of $10,000 at a rate of return of 3.00% earns $5,579.67 in interest over 15 years thanks to compounding interest. Please note how the interest earned increases every year. In comparison, by not compounding and instead paying out the interest at the end of each interest cycle, you only earn $4,500 (15 x $300) over 15 years.

interest table

While the impact of compounding interest may seem negligible at first, as time goes on it becomes more pronounced. In our previous example, for instance, compounding your interest would result in $14,272.62 in interest earned after 30 years while not compounding the interest would give you only $9,000 (30 x $300).

The Rule of 72

The Rule of 72 is a simple formula that helps you estimate how long it’ll take for your initial investment to double by compounding interest. The formula states:

72 ÷ Rate of Return = Number of years to double initial investment

So if you’re earning 3.00%, for instance, it would take 24 years to double your investment (72 ÷ 3.00 = 24).

The Rule of 72 has its limitations. It gives you an estimate based on a one-time investment but for more advanced calculations that include ongoing payments towards your investment or rate changes you might want to consider using an interest calculator.

The Bottom-Line

If you’re saving for retirement, make compound interest and time work for you. The sooner you start saving the better.

 

Check out our Compound Interest Calculator to see how much your savings will grow over time!