Getting a handle on personal finances always feels more complicated than it really is, especially for college students. That’s because many students get intimidated by a subject that they are not familiar with.
However, when it comes to money what you don’t know CAN hurt you. College is great because it exposes students to a wide variety of subjects and materials, but after graduation many students forget much of the details as they progress into their life. This sets poor learning precedence, as there are certain subjects that teach lessons worthy of a lifetime. Learning about how money works is one of those subjects, but much of the high level theory taught in class is hard to connect to the daily wallet concerns most students have. They need financial literacy simplification for understanding, and application for proof of relevance. A great place to start is the rule of 72, a simple idea with a powerful and useful message.
What is the rule of 72?
The rule of 72 is a rule of thumb used to estimate the time-value of money. It’s an effective way to calculate the value of an investment, or an outstanding loan balance over time using a specific interest rate. Best part is that it’s simple enough to calculate in your own head without a calculator!
Here is an example: Take the number 72. Divide it by an interest rate, like 6%.
72 / 6 = 12 The answer represents the number of years it takes for the balance to double; in this case 12 years.
So let’s say there is an outstanding loan balance of $10,000 carrying 9%.
72 / 9 = 8 If no payments were made on the loan, and the balance continued to grow and compound normally it would take 8 years for the balance to grow to $20,000.
Unlock the power of The Rule of 72
The rule of 72 is but a humble rule of thumb made powerful through it’s daily usefulness. The real strength of the rule is found through it’s applicability and the thoughtfulness of the individual. Learning fundamental rules like this will help to unlock the power of true financial literacy; the ability to improve your decision making process involving money.
It helps with purchasing decisions
When you make purchases with a credit card, the interest that accrues adds to additional costs beyond the sticker price. Credit card companies make their money through interest charged, and rely on consumers to make purchases that would normally be un-affordable. The resulting payments towards debt include the interest generated by the original purchase. If you have a well tuned financial mind, you think twice before making a credit card purchase because of the additional costs. If making a big ticket purchase on a credit card, use the rule of 72 to estimate how quickly interest can pile on. Then reconsider your purchase and find a way to save money and buy with cash, or use a combination of credit and cash to reduce overall costs.
It helps with long term savings
The rule of 72 can help estimate long term savings. For example, how long would it take $20,000 to grow to $40,000 using a 12% rate of return? 72/12 = 6 years. What about if it’s at 2%? 72/2 = 36 years. Once the impact of rate is made clear, the next logical question is “where do I get a 12% rate of return?” and this leads to an investigation of business and investment options. The simple acknowledgement of these options can help a student learn about the importance of saving and the options used to help savings grow.
It helps with personal budgeting
Q: Why do some people carry revolving credit card balances and student loan debt while consistently keeping extra money in the bank?
A: Because they don’t know any better.
When you learn to appreciate the Rule of 72, you begin to question some everyday financial habits you may have. A financial habit that’s detrimental to many is being “cash rich” and and full of debt. This is when someone runs credit card balances month after month and/or has lot’s of student loan debt, but only makes the minimum monthly payment to each, leaving extra cash on hand. Every month there is more than enough cash available to spend now, but the debt balances are not reducing fast enough. The logic behind this stems from the fear of over-withdrawing from the checking account for current expenses. More often, what is required in this situation is personal austerity. Instead of worrying about paying for current expenses, think of ways to cut current expenses and forward the excess towards debt payments. It’s the only effective way to eliminate long term debt beyond radically increasing income.