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Home»Retirement»What is the difference between ordinary annuity and annuity due?
Retirement

What is the difference between ordinary annuity and annuity due?

July 8, 2024No Comments3 Mins Read
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An annuity is a financial product that offers a consistent income stream over a specified period, commonly used in retirement planning to convert a lump sum investment into regular payments.

There are various ways to structure annuity payments, such as ordinary annuities and annuities due. The timing of these payments can significantly impact the annuity’s overall value.

Understanding Ordinary Annuities

An ordinary annuity involves receiving equal payments at the end of each period, whether monthly, quarterly, or annually, depending on the terms of the annuity contract.

How Does an Ordinary Annuity Operate?

When you invest a lump sum in an annuity, the insurance company managing your contract generates periodic payments for you. These fixed payments are calculated based on factors like the initial investment, interest rate, and total number of payments.

Key factors include:

  • Present value (PV): Initial investment amount.
  • Payment (PMT): Fixed amount received at the end of each period.
  • Interest rate (r): Annual rate of return offered by the annuity.
  • Number of periods (n): Total payments received.

The formula to calculate payment amount for an ordinary annuity is:

PMT = (r/12 * PV) / (1 - (1 + r/12)^(-n)

Illustrative Example

Suppose you invest $100,000 in an annuity with a 5% interest rate for 10 years, receiving monthly payments:

PMT = (0.05/12 * $100,000) / (1 - (1 + 0.05/12)^(-120)

PMT = $1,060.66

Therefore, you would receive approximately $1,060.66 monthly for 10 years in an ordinary annuity.

You can use Google Sheets or Excel to calculate annuity payments using the PMT function under financial.

Understanding Annuities Due

An annuity due involves receiving the initial payment and subsequent payments at the beginning of each period, impacting the annuity’s value due to the time value of money.

How Does an Annuity Due Function?

Similar to an ordinary annuity, you invest a lump sum with an insurance company, but receive payments at the beginning of each period.

The payment calculation for an annuity due considers the time value of money.

Illustrative Example

Using the same example as the ordinary annuity, the monthly payment for an annuity due with a $100,000 investment, 5% interest rate, and 10-year term is:

PMT = 100000 * (0.05/12 / (1 - (1 + 0.05/12)^(-120)) * (1 / (1 + 0.05/12)))

PMT = $1056.25 (rounded)

Due to receiving the first payment earlier, the annuity due payment is slightly lower ($1,056.25) compared to an ordinary annuity ($1,060.66).

Key Differences Between Ordinary Annuities and Annuities Due

The primary distinction between the two is the timing of payments. Annuities due pay at the beginning of each period, potentially resulting in a higher future value due to the time value of money.

Receiving payments earlier with an annuity due may offer a slight advantage.

Online calculators or spreadsheet applications like Excel can help determine the present and future value of annuities by inputting the interest rate, payment amount, and duration.

Conclusion

Understanding ordinary annuities and annuities due is crucial for making informed financial decisions. The timing of payments can significantly impact the annuity’s value and income stream. Online tools simplify the calculation process for both types of annuities, ensuring accurate financial planning.

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