How To Shift Between Simple And Compound Interest Rates

wealthymattersNow that banks and other financial institutions are having to compete to raise deposits from the public,quite a few are resorting to a bit of window dressing.They quote annual yields,annualized returns or simple interest rates instead of compound interest rates for multi-year deposits.

Now a simple interest rate looks more impressive than a compound interest rate over longer periods of time ;so do check what sort of interest the seller is offering before locking your money away at a rate that looks great.

Here is a simple step-by-step way  that you can use to mentally estimate the compound interest rate that is equal to any simple interest rate. Read more of this post

Some Financial Thumb – Rules

Financial thumb-rules are rough guides for making sensible financial decisions .However they have their  infirmities and so need to be used in the right context.Following are a few basic financial thumb-rules:

  1. Pay yourself first rule: From any money you make, put away atleast 10% first before you pay any bills or debts or do anything else with the money i.e. make your investments the first obligation on your money.The general idea is that this money will start working for you by earning interest , gaining in capital value or giving you rents etc. and in time you will need to work less and less as your money starts working for you.
  2. The emergency fund rule: Build a corpus equal to 3-6 months worth of expenses of your household.Life is uncertain and you never know when somebody might meet with an accident , fall sick , suffer losses in business , lose a job or suffer loses due to fires or natural calamities ,war, civil strife etc.The money is to take care of immediate expenses,provide a cushion to fall back on till you find your feet again and if necessary provide a small stake to start over again.The money needs to be kept in a safe place where there is no chance of loss of capital and where it can be withdrawn immediately and without hassles.
  3. 100 minus your age rule:This is a thumb-rule to determine how much of your paper assets should be in equities.The general idea is that as you grow older and wealthier you want less volatility and less risk of capital loss.Volatility might complicate withdrawls from the corpus in retirement and lost capital might not be so easily made up for later in life, after retirement.
  4. The 10,5,3 rule : This rule states that you can on an average expect returns of 10% on equities,5% on bonds and 3% on liquid cash and cash-equivalent accounts in the long run.It’s important to remember this rule before reaching for that extra half percent that might lead to capital loss. Read more of this post

Rule of 72 , Rule of 70 , Rule of 69

wealthymatters.comThese are nifty rules of thumb to quickly calculate the  years it will take to double our initial investment in a compound interest scheme.

The Rule of 72 is the basic thumb rule to be used in case of annual compounding.Rule of 70 is used in case of semi-annual compounding.Rule of 69 is for continuous compounding.

For example, to find out how long we have to wait for our principal to double in a scheme with an interest rate of 8% compounded annually,we have to divide 72 by 8 to get the answer 9 years.

We can also use the thumb rules to find out how fast the purchasing power of a currency will halve under an inflation regime.So if the annual inflation is 12% the purchasing power of the currency halves in 6 years.

Another cool use of the these rules is to figure out  the impact of management fees,entry and exit loads,mortality charges, administration fees etc. of  structured financial products such as mutual funds ,ULIPS and Pension Plans on potential gains. To find out the impact we divide 72 by the expense ratio. For example, if the mutual fund has an expense ratio of 2%, then  in 72 / 2 = 36 years,half the potential gains have been lost because money deducted for various charges does not get the chance to compound.

As a foot note,let me add that the Rule of 72 is most accurate in the 6-12% range.Also we can extend the Rule of 72 out further,and determine other approximations for tripling and quadrupling. To estimate the time it would take to triple our money, we can use 114 instead of 72 and for quadrupling,  144.

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