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The Time Value of Money and the Rule of 72

Posted on July 28, 2015 at 12:20 AM

Time is literally money. Inflation, the rate of interest, and how interest is calculated has a tremendous affect on the future value of your money. If I offered you one hundred dollars would you take it today or tomorrow? The average person would not even give that question a second thought and take the money now. That average person would be making the correct decision. The basic concept of the time value of money is that money received today is worth more than money received in the future. The obvious reason to take the money is because it might not be there tomorrow, but also consider inflation and interest. Inflation is the change in the level of prices for goods and services which negatively affect the purchasing power of money. Just ask your parents how much was gas, housing, and clothing in their younger years. Or ask your grandparents how much they paid for a new car, a loaf of bread, or how much was their salary. The difference in what they paid for it and how much it costs now will shock most people.

The other factor affecting the time value of money is interest. Interest is calculated two ways:

• Simple interest is interest only calculated on the original balance.

• Compound interest is interest calculated on the original balance as well as previous interest earnings. Essentially it is interest paid on interest.

Interest rates can be used to determine how good (or not so good) a potential investment is likely to be. Another thing to consider when making wise investments is determining how often your money will double. Look at what happens to money when it is doubled:

$1,000….$2,000….$4,000….$8,000….$16,000….$32,000….$64,000….$128,000

If the interest is compounded annually, it can help you determine how long it will take your money to double by using one simple rule: The Rule of 72. The rule states that to find the number of years required to hold on to your investment in order to double your money, just divide the interest rate by 72.

Let’s say you invested $10,000 in a savings account to fund your newborn child’s college education. The interest rate on this savings account is 5% compounded annually. Assuming you made no more contributions to this savings account it is safe to say it will take 14.4 (72/5=14.4) years for that $10,000 to become $20,000. The rule is to be used to give you a gauge of the potential earnings of an investment but should be primarily used when the interest rate is below twenty percent. As you start dealing with rates over 20%, the rule gets more and more inaccurate.

The Rule of 72 can also be used inversely to determine the interest rate needed to double your money in a given time. John Doe was considering the purchase of some real estate notes for his investment portfolio. He planned on spending $50,000 and wanted to double that in six years. By using the rule, John discovered that the real estate notes had to yield at least 12% (72/6=12) interest in order for his money to double in six years.

Analyzing investments is just one way to use The Rule of 72. It can also be used to analyze debts. Consider how fast your debt on high interest credit cards can double if you pay little or nothing on them.

Harris Homes is the premier real estate solutions provider in the DC/MD/VA area. Contact us today to see how we can help you start saving money and getting greater returns on your real estate investments. Give us a call @ 443.219.7465. Visit our Company Profile to learn more about us.

 

Categories: Financial Literacy

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