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Thinking In Rates

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Not everyone is big into investing, nor do we know all the rules of money.  But one thing that we all kinda have a clue about is interest and interest rates.  We know that if we get a loan and have an 8% interest rate, we are paying that 8% every month.  Yeah, it sucks but we know we have to pay it, so we pay it.  We tend to look at a rate and get a feeling for if it is good or bad, but do you really know the impact?  Well if you have ever purchased a car or a house and you financed it, you were probably told the total amount you will have paid once the loan is paid off.  It is usually some astronomical number that you don’t even want to hear, so you forget about it quickly and keep moving.  I don’t blame ya.  The takeaway here is that we tend to think in rates.  Let’s look at another rate that most people are familiar with…

Inflation…Yuck!!!

I could give you some very technical answer on what inflation is, but I am going to keep it simple.  Inflation simply means your dollar will be worth less a year from now that it’s worth right now.  But how much less?  Inflation is usually between 2 and 3% every year.  This means that if you put a dollar in your mattress and don’t spend it for about a year, that dollar will not be worth a dollar any more.  It will be worth about .98 or .97 cents due to inflation.  You lose 2-3 pennies on every dollar a year.  This is definitely not ideal, but it does ground us a bit and help us get a feel for rates and the numbers behind them.  But enough of this talk about what we are losing.  Let look at money we can make.

Return Rates Of Investment

When we are looking to invest our money, we will look to see what the rate of return is.  You may learn that investing your money in the S&P500 will earn an average rate between 8-10%.  But is that good or bad?  Well, let’s look at what we know from what we pay.  We know that we don’t like paying 8% or more in interest on a loan to anyone, because they are winning.  So, if you can get 8% or more as a rate of return on your money invested, then I would say that’s a winning rate.  We also know that, due to inflation, we lose 2-3% a year.  Though this is not ideal, it is just a few pennies on a dollar, so it’s not horrific.  Thus, if you earn a 2-3% rate of return on your money, then you aren’t really earning much.  You could say that all you are actually doing is keeping the value of your dollar.  That’s not bad, but it’s not the rate of return we want either.  There’s a better and more accurate way to understand what those rates mean…

The Rule Of 72

Simply put, this is a rule/formula that will help you determine how many years it will take to double your money given a certain annual return (i.e. rate).  If you can do simple math, you can figure this out.  Let’s look at the 8% that we used as a base above.  If we receive an 8% return on our investment, it will take us 9 years to double our money.  How’d I figure that out?  Simple, just divide 72/8 (the rate of return).  That comes out to 9 years.  It would take you 9 years to double your money.  So, if you put $100 into an investment with an 8% return, it would take you 9 years to reach $200.  That’s not too bad.

Let’s look at the 3% return (inflation rate comparison).  If an investment gives us a return of 3%, then it would take 24 years (72/3) to double our money.  So, with a $100 investment at a 3% return, it would take you 24 years to get to $200.  That’s not so good.  But what is good is that The Rule of 72.  It will help you evaluate where to invest your money with a simple formula to determine how long it will take to double your money at a given rate of return.

The Takeaway

When it comes to what we have to pay for a loan, inflation, and making money, we always tend to think in rates.  Whether it be the 8% interest rate on our loan, the 2-3% rate of inflation, or the 10% rate for return of investment, we tend to think in rates.  We tend to determine how good a rate is compared to other experiences we’ve had with rates.  But the The Rule of 72 changes all of that.  You can quickly determine how much money you can make with a certain rate of return by simply dividing 72 by the annual rate.  This can help you determine the best investment and understand exactly what it means for your dollar.  It is still good to think in rates, but why not do some simple math behind it to understand it better???

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