Estimating Compound Interest

Published on Sunday, February 08, 2015 in , , ,

freephotoshop.org's Money stack imageA recent question on the Mathematics StackExchange about mentally the compound interest formula caught my attention.

It got me thinking about good ways to work out a good mental estimate of compound interest.

Part of what makes it so tricky, is that compound interest doesn't work in a straight line, like much of the math with which we're familiar. Compound interest builds on itself exponentially (not surprising since the formula is a exponential expression). This is a good point to re-familiarize ourselves with the basics of the time value of money:

For a more detailed guide to interest rate mathematics, I suggest reading BetterExplained.com's A Visual Guide to Simple, Compound and Continuous Interest Rates.

BINOMIAL METHOD: The Mental Math wikibook suggests the following formula: To estimate (1 + x)n, calculate 1 + nx + n(n-1)2 x2.

It is an interesting formula, especially considering that the first part, 1 + nx, is basically the simple interest formula. However, after using Wolfram|Alpha to compare the actual compound interest rate formula to this binomial estimation of compound interest method, you see that it really only gives close answers when x is 5% or less, and n is 5 time periods or less.

If your particular problem qualifies, that's not bad, but what about longer times?

RULE OF 72 AND OTHERS: Last July, I wrote another post about estimating compound interest discussing the rule of 72 for determining doubling time, as well as the rules for 114 (tripling time) and 144 (quadrupling time). Note especially that you can work out the effects of interest of long time periods with a little simple addition.

Yes, the rule of 72 has been explained many places, such BetterExplained.com's Rule of 72 post, and critically analyzed, such as MindYourDecision.com's Understanding the rule of 72 post and the related video, but as long as you understand its proper use and caveats, it's an excellent tool.

Understanding where the rule of 72 comes from, you can actually work out other rules for other multiples of your original amount, which is how the rules of 114 for tripling and 144 for quadrupling came about. If you want to estimate how long your money takes to grow to 5 times the original amount (quintupling), there's the rule of 168. Similar to the other rules, you can work out quintupling as 168time ≈ interest rate (as a percentage) and 168interest ≈ time.

To help increase the accuracy of needed estimates, you can also remember the 50% increases between each of the above rules. For a 50% increase, for example, there's the rule of 42. For 2.5 times, there's the rule of 96, for 3.5 times, there's the rule of 132, and for 4.5 times, there's the rule of 156.

This may seem like too many rules to remember, but there are a few things that help. First, keep the rules of 72, 114, 144, and 168 in mind as primary markers for 2×, 3×, 4×, and 5× respectively. Note that these are all multiples of 6, and that the “half-step” rules are also multiples of 6, and fall between the other numbers. So, if you forget how to work out 2.5×, you can realize that the rule is somewhere between 72 and 114, and then recall that 96 is the rule you need! Here is a handy Wolfram|Alpha chart for which rules go with which amounts.

“RULE” EXAMPLES: In the video above, Timmy needs to find out how long it will take to get 10 times his money at a 10% interest rate. Since we only have rule up to 5, how do we work this out? Well, 10 times the money is basically the same as quintupling the money, then doubling that amount of money. So, we can work out the quintupling times and doubling times at 10%, then add them together!

For quintupling, we use the rule of 168 to find that 16810 ≈ 16.8 years. Since these are estimates, you can usually round up to the nearest integer to help with the accuracy. So, his money will quintuple in about 17 years. How long will it take to double from there? We use the rule of 72 for doubling, so 7210 ≈ 7.2 years, and rounding up gives us 8 years. Since it will take about 17 years to quintuple, and about 8 years to double, then getting 10 times the amount should take roughly 17 + 8 = 25 years. In the video, they note that it will take 26 years, so we've got a good estimate!

In his Impress by doing compound interest in your head post, Martin Lewis describes the following interest problem: “What is the APR, ie annual interest rate, if you borrowed £80,000 and had to repay £200,000 six years later?”

Since £200,000 ÷ £80,000 = 2.5, we can use a simpler approach than Martin Lewis did in his article, as we know that the rule of 96 with the 6 year time span to work out the annual interest rate. 966 ≈ 16% interest, the same answer Martin worked out!

USING e: Once you start getting too far beyond 25 time periods (25 years for annual interest rates), you should start using e (roughly 2.71828...) to estimate compound interest over the long term. Last March, I wrote Calculate Powers of e In Your Head! to help with this exact task. At this point, you're probably more concerned with the scale of the answer, rather than the exact answer, so working out just the equivalent power of 10 is all you really need.

SHORT VERSION: So, instead of providing one way to estimating compound interest, here are 3 methods for different scale problems. If the rate is 5% or less, and the interest is applied 5 or fewer time, the binomial method is the way to go. If your problem is larger than that, and covers less than 25 time periods, then use the rules approach (rule of 42, 72, 96, etc.). If the interest is applied more than 25 times, use e to get an idea of the scale.

It may not be the simplest estimation approach for compound interest, but if you're stuck without a calculator, this will help you get by until you can more accurately crunch the numbers.

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