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Einstein’s Contribution to Personal Finance

Albert Einstein was absolutely fascinated with the concept of compound interest.  He has been quoted as saying: “The most powerful force in the universe is compound interest”.  This was coming from a physicist and not a financial guru.  Some Einstein biographers say that he was so captivated with the concept of compound interest that he created a very simple formula called the “Rule of 72.”  I don’t care who created the Rule.  It provides us with a good approximation of future investment savings.  The important point is that the power of compound interest was validated by one of the greatest scientist in history.

What is compound interest?

Some say compound interest is earning interest on interest.  Another way to describe compound interest is that it’s interest earned on principal plus interest that was earned earlier.  Here is a simple example:

Let’s assume you have a savings account that earns compounded interest annually at 10% (which is unrealistic but it makes for a good example).  A $100 is deposited in the saving account that earns 10%, the depositor will be credited with $110 at the end of the first year.  Then at the end of the second year the account is credited with $121.  That extra $1 was earned from the $10 of interest earned from the first year

Interest can be compounded annually, quarterly, half-yearly or daily.  There is a simple formula to calculate compound interest but I am not going to bore you with it.  But it is important to understand that compound interest calculation is very different than a simple interest calculation because a simple interest calculation does not compute interest earned on the interest earned from the previous year (or interest on interest). 

I don’t know if compound interest is the “most powerful force in the universe” but I do know it is pretty powerful and is something that we should take advantage of as investors.  One way to harness the power of compound interest is by starting a savings plan early (hint: younger people) and also having a consistent savings plan such as saving or investing $100 per month.  Just take a look at the power by using this calculator.

Rule of 72

The rule is as follows:

72 divided by interest rate earned = Number of periods it takes to double the money.

Here is an example:

If you are earning 6% (compounding annually) on a savings account.  Divide 72 by 6 which equals 12, which means that it would take 12 years to double your money.

It works backwards too: say you want to double your money in 12 years and you want to know what interest rate you need to earn. Divide 72 by 12 years to get 6%.  Amazing?

There are some limitations on the Rule of 72: 1) it is an approximation - kind of like a “back-of-the-envelope” calculation; 2) it works very well with annual compounding but if you have daily compounding, such is the case with many savings accounts, you have to remember to adjust interest rate earned by 365 days; 3) it assumes that the interest rate earned is constant or stays the same which is not the case with most investments; and 3) it does not work well with higher interest rates (ex. greater than 10%) because it is not as accurate.

Some finance professionals say that the Rule of 72 is obsolete because of financial calculators.  I would argue that it is not obsolete if it can still show the power of compound interest to someone who is not familiar with the concept.  I thank Albert Einstein for recognizing the power of compound interest.