There are many online calculators available today that help you determine the equated monthly payments on a loan offer, work out the premiums on an insurance plan, or compute how a particular investment would work out.
However, sometimes back-of-the-envelope calculations are faster if done literally on the back of an envelope than if you were to go online, search for a calculator, feed in the required inputs, etc.
One popular back-of-the-envelope formula is the rule of 72 in finance, which can help you calculate how many years it would take to double your principal investment at a given interest rate.
Inversely, the rule of 72 formula can also help compute the annual rate of compounded return on investment if you know how long it would take for an investment to double. This formula could come handy when it comes to calculating your mutual fund investment returns.
The rule of 72 formula:
Years to double = 72/interest rate or the rate of return on an investment
So, say you make an investment that pays you an annual interest rate of 8%, then as per the rule of 72, it would take nine years for your initial investment to double.
Alternatively, another use of the formula could be to calculate the devaluation of your investment at a given rate of inflation. The inflation rate denotes the rate at which your money loses its purchasing power over time.
Suppose you expect inflation to average at 4% per annum going ahead, then 72/4 = 18 years. As in, it would take 18 years at an inflation rate of 6% for your investment to halve in value.
However, it is necessary to keep in mind that the rule of 72 is an effective means of calculation where compound interest is involved, i.e. where one calculates interest on the principal and accrued interest. It is this particular aspect that makes calculations using the rule of 72 such a thrilling prospect.
How accurate is the rule of 72?
The rule of 72 is a simplified version of a more complex equation. It is to help make a few quick calculations and get a rough idea about an investment. However, it is prudent that investors consult certified professionals for in-depth, actionable financial advice.
What calculations can I make using the rule of 72 formula?
The use of the formula is not limited to calculating your investments pertaining to fixed deposits, mutual funds, the stock market, etc. You can also use it in the context of population growth, macroeconomic figures, etc.
Are there any restrictions to using the rule of 72?
The application of the rule of 72 is limited to cases where compound interest is involved.
When you calculate interest on the original principal investment plus accumulated interest, it is compound interest.
The rule of 72 is an effective and simple tool to help you make rough, back-of-the-envelope calculations. However, it is always advisable to contact a professional to fully understand the risks and rewards of a specific investment opportunity.