If you are a regular Future Proof reader, you likely appreciate the concept of Time Value of Money (TVM). If you are new to the site, check out Why You Should Start Saving - Yesterday! At the core of TVM is the concept of compound interest - about which Albert Einstein reportedly said:
Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.
While Einstein probably never said half of the stuff that we claim he said, the importance of compound interest cannot be understated, especially for healthcare professionals at the beginning of their careers. Let's take a look...
Investopedia defines "compound interest" as follows:
Compound interest is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as “interest on interest,” and will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount.
The total accumulated value, including the principal sum plus compounded interest, is given by the formula:
- A is the total accumulated value after a set period of time t.
- P is the principal sum
- i is the nominal interest rate
- n is the compounding frequency
- t is the overall length of time the interest is applied (usually expressed in years).
But who wants to do math?! Luckily there are many compound interest calculators available, here's one from Bankrate.com.
Shortcut - "Rule of 72"
There is no need to turn to calculators however. Through the magic of math, there is an amazingly simple approximation of the above formula known as the "Rule of 72." Even the most math-challenged of us should be able to do this basic calculation:
- t is the number of years required to double your investment
- i is the nominal interest rate.
- Interest is compounded on an annual basis.
Example: If you make an investment with an annual return of 12%, it would take approximately 72/12 = 6 years to double your investment. If you invested $10,000 at 12% annual return at age 16, by age 22, you will have $20,000; age 28, $40,000; age 34, $80,000; age 40, $160,000; ... by age 64, your $10,000 initial investment would have turned into $2,560,000!
Regardless of whether Einstein ever called it the "8th Wonder of the World," compound interest is extremely important for your financial health. It can work for you (investments) or work against you (debt). The "Rule of 72" is one of my favorite math formulas of all time. It provides a quick way of estimating your investment returns over time. It is reasonably accurate. Best of all, I can do it in my head. Give it a try, you may be pleasantly surprised.