GnosticWarrior
March 23rd, 2007, 01:07 AM
I was just curious to know who many people out there know what the rule of 72 is? After observing people's money allocation decisions, I wondered if those people understood this rule. I feel that its the most important rule in finance. This rule can be very useful in most of your financial decisions.
The rule of 72 is a simple formula that is used to determine how many years, at what interest rate, does my money need to compound in order to double. It's not accurate to the penny, the dollar, or even more, but its a good, quick ball park calculation.
Now most might have used this to calculate how long it would take their money to double in a savings account, CD, or bond earning a particular interest rate. But how many have used this rule when deciding to make a loan? If you make a loan, the rule of 72 is still at work. A loan of $100 at 6% interest will double to $200 in 12 years if no payments were made. You can see its power better in a mortgage. With a big principal upfront, most of your monthly payments are going toward the interest and very little is actually paying down the principal which is generating future interest.
That's why for most people, making extra payments to pay down your principal on a mortgage is one of the best financial decisions one can make. Actually, even better than putting that money in your savings unless you know you need it. Not paying off your credit card and keeping a balance is financial suicide.
I was going to save it for another thread but, its also important to consider the after tax consequences of investing or borrowing money. Assuming an overall tax rate of state and fed combined of 30%, if I was looking to invest in a CD or paying down my mortgage, the CD would have to yield approx. 8.6% on a pre-tax basis to be equivalent to they money I would save by paying down my mortgage at 6%. You can also look at it another way, if I decide to make a loan at 6%, It is actually costing me 8.6% to be able to pay it back.
So the next time you decide to spend, save, or borrow, remember the rule of 72 and how this transaction will affect your overall finances.
The rule of 72 is a simple formula that is used to determine how many years, at what interest rate, does my money need to compound in order to double. It's not accurate to the penny, the dollar, or even more, but its a good, quick ball park calculation.
Now most might have used this to calculate how long it would take their money to double in a savings account, CD, or bond earning a particular interest rate. But how many have used this rule when deciding to make a loan? If you make a loan, the rule of 72 is still at work. A loan of $100 at 6% interest will double to $200 in 12 years if no payments were made. You can see its power better in a mortgage. With a big principal upfront, most of your monthly payments are going toward the interest and very little is actually paying down the principal which is generating future interest.
That's why for most people, making extra payments to pay down your principal on a mortgage is one of the best financial decisions one can make. Actually, even better than putting that money in your savings unless you know you need it. Not paying off your credit card and keeping a balance is financial suicide.
I was going to save it for another thread but, its also important to consider the after tax consequences of investing or borrowing money. Assuming an overall tax rate of state and fed combined of 30%, if I was looking to invest in a CD or paying down my mortgage, the CD would have to yield approx. 8.6% on a pre-tax basis to be equivalent to they money I would save by paying down my mortgage at 6%. You can also look at it another way, if I decide to make a loan at 6%, It is actually costing me 8.6% to be able to pay it back.
So the next time you decide to spend, save, or borrow, remember the rule of 72 and how this transaction will affect your overall finances.