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As an investor, you may have heard of this real estate investing concept and wondered, "What is the rule of 72?" The truth is that you don't have to be a financial advisor or credit card expert to benefit from this equation. We'll look at what the rule of 72 is, how it works, and how you can use it to gain insight into your returns.
What is the rule of 72?
In investing, the rule of 72 is an easy way to determine how long it will take for your investment to double in value, provided that it has a fixed annual interest rate or rate of return. It's used to give you a sense of how compound interest can potentially help you grow your portfolio.
Many investors use this equation as a rule of thumb because the math is simple enough to be done without the help of a calculator. Even if you're looking to do more than double your money, knowing how long it takes to do so will go a long way toward letting you know how long it will take to reach your goals.
That said, it's important to keep in mind that this rule provides you with a close estimation of the time it takes to double your investment. It also works best with lower rates of return. Once the rate of return gets above 15%, the estimation starts to get further off the mark.
How the rule of 72 works
When using the rule of 72, all you need to do is divide 72 by the rate of return or interest rate. In equation form, it looks like this:
Years to Double = 72 / Rate of Return
As an example, let's say that you invested $100 at a 9% annual rate of return. In this case, you would calculate the following to determine how long it would take your initial investment to reach $200:
Years to double = 72 / 9
8 Years = 72 / 9
The above equation is a particularly good example because nine divides cleanly into 72. However, that doesn't always need to be the case. The table below will give you a sense for how this rule works at different rates of return.
|Annual Rate of Return||Years to Double According to the Rule of 72||Actual Years to Double|
Notably, you can also flip the equation to find out the fixed interest rate that you need to receive in order to double the present value of your investment. In that case, you would flip the divisor and quotient in the rule of 72, so that our equation would look like this:
72 / Number of Years = Necessary Rate of Return
If you were to use the same example from above, you would calculate the following:
72 / 8 = 9%
The history behind the rule of 72
The number 72 works as a mental math estimation because it's easily divisible by quite a few numbers. In actuality, using the number 69.3 will give you a closer result, but for most people, doing that math would require a calculator.
As for where 69.3 comes from, one of the first known references to the rule dates back to the 1400s. It's mentioned by Italian mathematician Luca Pacioli in his book Summa de arithmetica.
This rule is based off of the time value of money formula, which is:
Future Value = PV × (1+r)n
In this formula:
- PV = Present Value
- R= Interest Rate
- N = Number of time periods
Here, since you're looking for the value of your investment to double, you would state the future value as two and the present value as one. The equation would look like:
2 = 1 x (1+r)n or, simplified, 2 = (1+r)n
The rule of 72 uses the concept of natural logarithms. In math, a logarithm is the opposite concept of a power. The natural logarithm can be explained as the amount of time needed to reach a certain level of growth with continuous compounding.
To remove the exponent, you need to take the natural log of each side of the equation.
ln(2) = n x ln(1 +r) or ln(2) = r x n
The next step is to divide both sides by the interest rate and, since the natural logarithm of two is equal to 0.693, the equation becomes:
0.693 / r = n
In order to get a percentage, you can multiply the left-hand side by 100%. It leaves you with:
69.3 / r% = n
Using the rule of 72 in real estate
Truthfully, you can use the rule of 72 in just about every scenario where you would want to estimate compound interest. However, this particular equation is most accurate when the interest compounds annually, which makes it an especially good match for real estate investing and, notably, retirement planning.
While it's true that you're not given an interest rate when you invest in real estate in the same way that you would be with credit cards or money market accounts, you can still take steps to calculate your annual return on investment (ROI). Then, you can use that number in place of the compounding interest rate in the rule of 72.
To calculate your rate of return on a real estate investment, you would calculate the following:
(Gain from investment - Cost of investment) / Cost of investment
In this case, your gain is from the rental income that you make plus any equity you've built. Meanwhile, your cost of investment would represent things like your mortgage payments, maintenance costs, and utility bills.
Once you have all the values in place, you can use this equation to compare how long it will take to recoup your investment with different rental properties.
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