Monthly compound interest, also known as force interest, occurs when a lender charges interest on a loan and the added interest increases the principal balance. The increasing principal balance also raises future interest amounts charged against the loan. This process works both for lenders loaning money to borrowers and investors looking to earn higher interest rates on invested capital. Monthly compound interest is quite common in the business environment; most banks charge and give compound interest as a standard process on loans and invested capital. The Rule of 72 is a specific compound interest principle that dictates how an investor may double his money with compound interest.
Under simple interest calculations, which differ from monthly compound interest, the bank will only charge interest on the original principal balance taken out by borrowers. This is not very common in the lending industry as it will result in lower earnings for the lender. Investors may also earn simple interest on invested capital. This represents a more fixed rate of interest as the investor will only earn interest on the original balance paid into an interest-bearing account. Future interest added to the principal is therefore disregarded in terms of earning power.
The Rule of 72 uses monthly compound interest periods to determine how many years an investor must wait to double his initial principal invested into an account. To properly calculate this figure, the investor must convert his monthly rate of interest to an annual rate; in other words, the monthly rate is multiplied by twelve. Many developed countries have historical interest rates that average between 6 and 10 percent annually. Using any figure within this range can help an investor determine the difference in years for doubling invested money.
To calculate the Rule of 72, an investor must simply divide 72 by his current annual compound interest rate. For example, an investor places $1,000 US Dollars (USD) into a monthly compound interest account at 8 percent interest annually. He can expect to double his principal in nine years. (72 divided by 8 equals 9) This basic method allows an investor to review different investments at different interest rates and calculate how long it will take to double his money.
Monthly compound interest investments can also help investors limit the effect of maintenance fees on his account. Many banks or investment firms charge a fee for managing investments. The annual charge for the account is often deducted from interest earned for the year. Compound interest accounts that earn interest each month will earn more money to offset the charges against the account.
