The Power of Compound – Thanks to ‘Albert’
Albert Einstein was known for his genius when it came to physics. Most famous, his theory of relativity.
In the world of economics, another great formula used in determining the power of compound against the value of an asset over time is the ‘Rule of 72’. This has nothing to do with physics, however it too was discovered by Albert Einstein!
Let’s explore this formula further.
Let’s assume we have a growth rate of 8% on an asset. If we divide that into the number 72, it tells us the time in which the asset will take to double in value. In this case, 9 years.
We will call this period in which an asset takes to double in value a ‘super-cycle’.
Now let’s apply this rule against property. (The rule of 72 can be applied to shares also).
If the property is worth $500,000 and we have a growth rate of 6 percent, when we apply the rule of 72, 6 into 72 goes 12 years, where the property, worth $500k, 12 years later is now worth $1 million.
Hard to believe? Let’s consider the price of an average home in 1970, in a midsize city like Brisbane, it would have cost you $10,000! If you sold that home now, there is a likelihood that the value would be in excess of $500,000!
A Commonwealth Bank share in 1990 would have cost $5. Today that share is valued around $80 and the annual dividend alone in 2017 is greater than the original share price.
The rule of 72 is a great ‘rule of thumb’ measure when it comes to estimating the future value of an asset over time.
Now let’s look at what happens when we extend the time based on the same growth rate.
Let’s say you are 30 years of age and you purchase a property for $500k with a debt (mortgage) on this property of $400k (80% LVR).
Let’s assume the growth rate of this property is 6%/annum. Divide 6 into 72 and there is a high probability that in 12 years (when you are 42 years of age) that your property will now be worth $1 million. We will call this ‘super-cycle 1’.
Now let’s repeat the example for a second ‘super-cycle’ and 12 years later (age 54) your property would be worth $2 million.
Now if we apply a third super-cycle, at age 66, the home is estimated to be worth $4 million.
The interesting thing here is if you only ever paid the interest on the loan and made no principle repayments, you would still owe 100% of the original debt!
Some people would be very uncomfortable with this strategy unless of course you knew the rule of 72!
Let’s dig deeper and see how this looks on paper.
Start of ‘super-cycle 1’
Home is $500k
Debt is $400k
Equity is $100k
The loan to value ratio is 80% i.e. $400k/$500k
Apply the growth rate of 6% into 72, 12 years later, your investment is worth $1 million
Debt is still $400k
Equity is $600k
LVR is 40% i.e. $400k/$1 million. Remember, you haven’t paid off 1 cent of your principle and you have still doubled the value of your property and cut your LVR in half!
Now if we repeat the process for a second super-cycle, at 54 years of age, your property is valued at $2 million
Debt is $400k
Equity $1.6 million
LVR is now at 20% i.e. $400k/$2million.
At age 66 (end super-cycle 3) your property is valued at $4 million.
Debt is $400k
Equity is $3.6 million
LVR is now 10% i.e. $400k/$4million
Everything halves or doubles in the opposite direction with the rule of 72. Perhaps the theory of relativity is working here also in that there is an equal and opposite reaction occurring over time!
You have never paid off any debt, yet you are in an extremely strong financial position.
The bank will be very comfortable with your position and will readily advance you more money so you can compound the cycle of wealth creation further if you wish.
Try something interesting, next time you speak to your accountant, mortgage broker or banker, ask them about the rule of 72 and see what they say!
Tips: This rule work best the earlier you start!
Traps: The rule of 72 should never be applied against depreciating consumer goods.
Whichever way you go about creating wealth, consider what lifestyle you hope to achieve not only at the end of your financial journey, but while you walk it. Remember we each only get one chance at life, and life is more than money.
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Disclaimer: Any advice in this publication is of a general nature only and has not been tailored to your personal circumstances. Please seek personal advice prior to acting on this information. Past performance is not a reliable guide to future returns. Before making a decision to acquire a financial product, you should obtain and read the Product Disclosure Statement (PDS) relating to that product.
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