THE POWER OF COMPOUND INTEREST, THE PROBLEM OF INFLATION, AND THE RULE OF 72
December 17, 2020
It’s almost impossible to overstate the importance of your savings account. Saving money for the future is one of the best financial habits you can acquire. But acquiring that habit does not come easily to everyone. Moreover, when the time comes to pay your monthly bills, the idea of money you won’t be spending for years or even decades to come can seem more abstract than concrete.
Financial experts can — and do — make multiple cases in support of savings. This article will focus on just one of the benefits offered by a form of passive income accessible to anyone who opens a savings account: compound interest.
Compound Interest Defined
Put plainly, compound interest is interest that earns interest. When you open an interest-bearing account, you make an initial deposit. This is your principal. You can add to this principal by making additional deposits.
Here, it’s necessary to understand that your bank also has a financial stake in your savings account. By opening a savings account, you are lending money to your bank, allowing it to use your assets to complete the many business transactions it makes every day. Interest payments are your bank’s way of compensating you for this use of your assets. Just as you pay interest on your loans, your bank pays interest on theirs.
Depending on your account’s terms and conditions, your bank will pay you this interest according to a regular schedule: monthly, quarterly, annually, etc. The same terms and conditions specify the amount of interest paid, traditionally expressed as a percentage of your principal. Annual Percentage Yield, or APY, is the most common formula used for this purpose.
Consequently, compound interest is also a form of reinvestment. As your principal grows thanks to these regular interest payments, so too does your interest-earning potential. And, the longer you remain a customer with your bank, the more it will reward you for your loyalty.
How Compound Interest Works
Again, compound interest accrues when your bank reinvests your interest payments in your savings (or investment) account, thus increasing your principal. Beyond this initial interest payment, interest is then paid on the expanded principal in each compounding period.
What does compound interest look like in action? Imagine that you have deposited $1,000 in a savings account that earns 1% in interest every month (or an APY of 1.004596%). At the end of the year, your account’s principal would total $1,010.05, or your initial investment plus $10.05 in earned interest.
Thanks to compounding, at the end of year two, your principal would be $1,020.19: $1,010.05 plus another $10.14 in compound interest. By the end of a decade — even if you never deposited another penny into this account — your principal would be $1,105.12. That extra 105 dollars (and change) is all the result of compound interest.
It’s also important to note that compound interest is different from simple interest. Simple interest applies only to your original deposit. Again, assuming you make an initial deposit of $1,000, you would earn $10 each year in simple interest. After 10 years, this account would have earned $5.12 less than the account earning compound interest. After 20 years, this difference would come to $21.30.
The Rule of 72 Defined
The Rule of 72 is a powerful demonstration of how much compound interest can help you reach your savings goals.
The Rule of 72 allows you to approximate how long it will take for your original investment to double thanks to compounding. Take the number 72 and divide it by the interest earned each year on your savings or investment account. The quotient is the number of years it will take for your money to grow by 100%.
Keep in mind that any deposits, contributions, or earnings that augment your original principal further activate the “magic of compounding.”
Putting the Rule of 72 into Practice
To put the logarithmic power of the Rule of 72 to work for you, remember that the formula provides an approximation of the time it will take for your investment to double. In fact, Rule of 72 calculations produce the most accurate results when applied to investments that earn an interest rate between 6% and 10%.
For example, let’s say you open an IRA that generates an annual return of 9.2% — the average earnings generated by the stock market over the last 10 years. Using the Rule of 72, 72 divided by 9.2 equals 7.8. After about eight years, and assuming you are reinvesting your earnings, your original investment will have doubled.
This doubling will occur regardless of the amount of your original investment. However, the larger your principal, the more dramatic the effects of this doubling.
The Rule of 72 in Reverse
The Rule of 72 formula also works in reverse. Divide 72 by the number of years by which you want your investment to have doubled. The quotient is the approximate annual interest rate you need to secure to achieve your goal.
If you are a 40-year-old who would like to double an investment you plan to liquidate upon reaching retirement age — 65 — divide 72 by 25. Your target interest rate would be 2.88%. Equipped with this knowledge, you can make an informed decision about how and where you invest your money.
Your Savings and Inflation
Inflation can be an existential threat to your financial security. Inflation often occurs when the economy is relatively healthy, but the demand for goods and services is higher than the supply. This imbalance can result in rising prices.
Other factors can contribute to inflation beyond the laws of supply and demand. A severe winter freeze in Florida, for example, might destroy a large part of the orange crop, leading to an increase in the price of both raw materials — oranges — and consumer products made from those materials, such as frozen orange juice concentrate.
Inflation can also be caused by a national calamity. To cite an extreme example, Germany’s defeat in World War I led to inflation so severe that, by late 1923, a single loaf of bread cost 200 billion German marks.
Fortunately, we have never faced an inflationary situation remotely that severe in this country. Nevertheless, inflation can still cause your savings to depreciate. If the inflation rate rises higher than the earnings on your savings or investment accounts, you’re effectively losing money. Runaway inflation can make it difficult for anyone living on a fixed income — such as retirees —to maintain a healthy standard of living.
The Rule of 72 and Inflation
You can also use the Rule of 72 to determine how long it will take for inflation to halve the value of your investment. As of November 2020, the annual inflation rate in the United States is 1.2%. Assuming this rate holds steady, savings worth $100 today would be worth $50 60 years from now.
Let’s adjust our previous example for inflation. At 2.88% interest, your investment will have doubled in value after 25 years. Over that same period, however, the cumulative inflation rate (again, assuming a steady annual rate of 1.2%) would total 34.75%.
So, an investment of $10,000 made in 2020 would only have the purchasing power of $6,475 in 2045. We can therefore project that $20,000 in 2020 dollars would have the purchasing power of $13,050 of those same dollars in 2045.
Therefore, an account that earns more than 4.1% in annual compound interest should be sufficient to offset the effects of inflation.
Limiting the Effects of Inflation
Luckily, whatever your age or the state of your personal finances, you can take measures to keep inflation from weakening your purchasing power.
- Create a personal or family budget. Sticking to a budget helps you watch what you spend — and spend only what you can afford.
- Look for cheaper alternatives. You might try buying store brands at the supermarket, and you may discover there isn’t much difference in quality or taste.
- Cut unnecessary expenses. Sometimes, what feels like a daily essential may actually be a luxury. That could be a gym membership, a subscription to a streaming service, or that trip you take every morning to the coffee shop. A few small personal sacrifices can go a long way toward boosting your savings.
- Remember your priorities. When dealing with the rising cost of living created by inflation, it’s important to keep your top priorities in mind. Don’t live beyond your means on credit cards, accumulating debt. Instead, do your best to continue to save and invest, especially for your retirement.
Although the Rule of 72 demonstrates the power of compound interest, you have to put this principle into action to reap its rewards. Start by setting a specific savings goal, placing your money in an account that offers the highest return, and remaining patient as your investment matures. Any progress will likely be incremental at first. However, over time, you will begin to see your savings grow by those hoped-for leaps and bounds.
Here at Guaranty Bank & Trust, we offer a diverse array of savings and investment account options optimized for growth. That includes money market accounts, certificates of deposit, retirement accounts, and Wealth Management services. We’re also one of the oldest and most respected community banks in the Lone Star State, one that’s helped Texans save and prosper for over 100 years. Opening an account takes as little as five minutes. Or, to explore all your savings and investment options, contact one of our friendly bankers by calling our Customer Care Center at 888-572-9881 or booking a video appointment today.