A Wedding Gift and Compound Interest

Dave and Michelle, two 25-year-olds, recently got married. They received $5,000 in cash as wedding presents and needed to decide what to do with the money. The answer didn’t seem obvious.

Looking over their finances didn’t take long because they didn’t have much money, especially since Michelle’s job at the time was only an internship. The two of them didn’t generally think of themselves as big planners and, at first, it seemed pointless to even consider investing for the long term. Dave suggested not investing right away and instead waiting until they had better jobs and made more money.

But Michelle told Dave about the Rule of 72. This rule approximates how many years it takes for an investment to double at a given annual rate of return. The formula is simple, as she explained, “Just divide 72 by the annual return and you’ll get the number of years it will take for your money to double.”

Rule of 72

72	divided by the return earned (in %)	1%	equals to	72	years for the amount to double
		3%		24
		6%		12
		10%		7.2

She noted that, with a 7% return, it would take about 10 years for their investment to double. At first, Dave wondered whether they could earn such a high return: 7% is a lot! But Michelle pointed out that they would be investing for the long term, and a diversified portfolio of stocks could yield returns in that range (even if it could go up or down).

This simple rule helped Michelle figure out that at a 7% annual return, the original $5,000 would grow to a whopping $160,000 by the time she and Dave turned age 75. When Michelle first pointed this out to Dave, he thought something had to be wrong with Michelle’s calculation. But, as she explained, the money grows because returns are compounded over time. In other words, all of the money including the earned return, gets reinvested every year, so that over the long term, there’s some serious build–up!

If Michelle and Dave waited until they were 55 years old to invest the $5,000 and earned the same 7% return, they would end up with about $20,000 by the time they were 75. And while $20,000 would be nice, the $160,000 they’d have if they invested right away would be even nicer!

Dave and Michelle decided to invest their $5,000 right away, giving it more time to grow. When their friends and family gave them $5,000, they never imagined it could turn into six figures. The young couple now understands that knowing more about compound interest and the Rule of 72 will be important for their future. Investing the money right away was the best wedding gift they could have given themselves!

Go Deeper

A great place to find data that will help you make informed financial decisions is the St. Louis Fed’s Federal Reserve Economic Data (FRED) site. For example, if you want to invest in the stock market, you can form expectations about the return you could earn by looking at the historical returns of a stock market fund, like the S&P 500. Let’s explore it together!

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Read the other two stories covering key financial concepts.