There is an often-told story that when Albert Einstein was once asked what mankind's greatest invention was, he replied: "Compound interest." There's even one claim that Einstein called compound interest the "8th Wonder of the World."
While there is some debate about whether Einstein really said any of this or not, there's no question that the compounding of interest is a brilliant thing. As another great American, Benjamin Franklin, described it: "Money makes money. And the money that money makes, makes money." That is probably the simplest explanation of compound interest you'll ever hear.
To be fair, compounding interest is a wonderful thing when you are earning it. When you are racking up interest on credit card debt, you'd probably agree with Einstein about it being the most powerful force in the universe.
While the compounding of money may sound complicated, especially if you don't have a computer spreadsheet handy, there's actually an easy-to-use tool that's been around for years that you can use to make calculations in your head. While it's not as precise as a spreadsheet, it can be really effective in helping you make decisions. It's called the Rule of 72.
Let me explain.
Many times when we're dealing with finances--especially when it comes to making new investments, buying real estate or capital spending--we talk about the potential of doubling our money and how soon that might happen. If you're considering making an investment with a given interest rate, you can use the Rule of 72 to figure out how long it will take to double your money.
Let's say that someone offered you the chance to invest in a piece of property in return for 10 percent interest for your loan. Divide 72 by 10, and you get 7.2--which is the number of years it will take for you to double the value of your investment.
You can also use the Rule of 72 the other way around. If someone promises they will double your money in three years, you can divide that into 72 and determine that they are willing to pay you an interest rate of 24 percent on your investment (72/3 = 24 percent). That can be a good fact check because 24 percent is really high, which means the investment is also likely to be very risky.
The Rule of 72 can also be very useful when it comes to calculating things like how often your money will double over the course of your career.
As an example, let's say that you are 30 years old and that you have already socked away $500,000 in an 401(k) account that generates a 10% annual return. But you plan on working until you're 65. If you leave your money in that account until you retire, how much will you have?
If you use the Rule of 72, you learn that you will double your money every seven years (actually 7.2). That means your money will double in value around five times over the next 35 years you're working, which means you'll have $1 million after seven years; $2 million after 14; $4 million after 21; $8 million after 28; and finally, you'll have a whopping $16 million when you retire in 35 years.
That's the kind of math that astounded Einstein and Franklin--and shows you the power of saving as much money as you can early in your career in a retirement vehicle like a 401(k), so that it can compound over time.
There's actually another quote attributed to Einstein about compound interest that should serve as a warning. He supposedly said: "He who understands it, earns it; he who doesn't, pays it."
So, if you want to make sure you fall into the first category, and not the second, use the Rule of 72 as your guide.