Compounding and the Rule of 72

January 11th, 2012 | interest, Money, Personal Finance, saving

The reason why it is so important for you to start saving early is the magic behind the concept of compounding and the rule of 72. People who wait until they are later to begin saving are going to have to save much more and much more quickly in order to catch up with the people that started saving much earlier on in their lives. There are two basic methods that you can use when it comes to calculating the interest that your savings will receive, one of which is simple interest and the other which is compound interest. Simple interest is generally calculated based on the initial investment that you make, but compounding interest means that are you earn interest payments on the initial investment that you made, it will be added to your initial investment and the new number will be used to determine the new interest payment.

The difference may not actually seem like a lot, but it is. The effect that compounding is capable of having over a long span of time is really astounding, especially when you are dealing with a larger initial investment or a higher return rate. Let us assume for example that you have $1,000 that you invest at 10 percent and the interest is compounded annually. What this means is that at the end of the year you will have earned a sum of $100, and you will now have $1,100. At the end of the second year, the interest is calculated based on the $1,100 rather than $1,000, meaning that you will earn $110 rather than $100, for a new sum total of $1,210.

Interest is typically compounded annually, monthly or on a daily basis. The more frequently that the compounding happens to take place, the faster that your money is going to end up growing as a result. As the balance continues to grow larger, the difference between compounding interest and simple interest is also going to become greater as well. If you put $7,000 in an account with 10 percent in interest, the numbers will astound you.

Another consideration is the rule of 72 which is a nifty little computation that allows you to estimate how long it will take for a certain amount of money to double in value based on a certain interest rate. To calculate this, what you do is divide 72 by the interest rate that you are expected to receive. So if you have an 8 percent interest rate, 72 divided by 8 is 9, meaning that it will take 9 years for your money to double with an 8 percent interest rate. If you are serious about investing your money, this trick can really come in handy because it teaches you to appreciate your interest rate and understand the investment that you are making.

Photo Credits: Leo Reynolds

Originally posted 2009-08-13 03:40:00. Republished by Blog Post Promoter

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