Carl Johnson Financial Literacy Jenks High School The Rule of 72

Terms to Know Compounded Interest – Interest earned not only on the principal, but also on the interest already earned Principal – The original amount of the loan Rule of 72 – The length of time (in years) that it takes for an amount of money saved to double when it receives compound interest. This length of time can be found by dividing the interest rate (expressed as a whole number) into 72 Simple interest – Interest calculated periodically on the loan principal or investment principal only, not on previously earned interest

Do You Have Interest? Why do we earn interest when we put our money into the bank? You are actually loaning the use of your money to the bank while it is deposited in your account The bank guarantees that your money is available as you need it The bank provides compensation in the form of interest for providing them the use of your money Interest can be calculated in two ways: Simple Compound

Simply Stated… Simple interest is calculated on the money that you loan or invest to someone Example – You have simple interest of 5% on $100 for 3 years 1 st year = $100 x.05 = $5 2 nd year = $100 x.05 = $5 3 rd year = $100 x.05 = $5 Total interest earned over a 3 year period = $15 Try one yourself…You have simple interest of 10% on $50 for 5 years 1 st year = $50 x.10 = $5 2 nd year = $50 x.10 = $5 3 rd year = $50 x.10 = $5 4 th year = $50 x.10 = $5 5 th year = $50 x.10 = $5 Total interest earned over a 5 year period is $25 Simple interest is not a bad rate of return, but there is a better choice

Compounding the Issue… Compound interest is calculated on the money that you invest or loan to someone, plus any interest that they have already paid you Example – You have compound interest of 5% on $100 for 3 years 1 st year = $100 x.05 = $5 2 nd year = $105 x.05 = $ rd year = $ x.05 = $5.51 Total interest earned over a 3 year period = $15.76 The longer that money is invested, the more impact that you receive from compounding Most interest earned is compound interest

The Rule of 72 The Rule of 72 is used to determine how long it will take your money to double using compound interest This will be calculated by dividing the interest rate (expressed as a whole number) into 72 Example – 72/6 = 12 It will take you 12 years to double your money at 6% compounded interest Try one yourself…You have a compounded interest rate of 8% The correct answer is 9 years

Why??? Why is the Rule of 72 useful?... It shows how risk and return are related To earn a higher interest rate, you have to take more risk…The more risk, the shorter the time that it takes your money to double

Your problem… Calculate the simple and compound interest, as well as how long it will take to double your money using the following information Principal - $72 Interest Rate – 6% Term – 4 years Simple interest 1 st year = $72 x.06 = $ nd year = $72 x.06 = $ rd year = $72 x.06 = $ th year = $72 x.06 = $4.32 Total interest earned over a 4 year period is $17.28

Your problem… Compound interest 1 st year = $72 x.06 = $ nd year = $76.32 x.06 = $ rd year = $80.90 x.06 = $ th year = $85.75 x.06 = $5.15 Total interest earned over a 4 year period is $18.90 Using the Rule of 72, it will take you 12 years to double your money