Understanding the Distinction between Simple Annuity and Annuity Due: A Breakdown
An ordinary annuity and an annuity due may seem like similar payment series, but they differ in the timing of the payments. An ordinary annuity pays at the conclusion of a given period, while an annuity due pays ahead of time.
The Basics of Ordinary Annunities
What is an ordinary annuity?
An ordinary annuity is a payment series where the payout occurs at the end of a designated period. This period could be a month, quarter, or even a year. The significance here lies in the fact that the payment covers the time that has already passed.
Let's take the example of a traditional mortgage to illustrate this idea. Your first mortgage payment is due on the first day of the month following a 30-day ownership period. This mortgage is an ordinary annuity because the payment is made in arrears. Car loans typically follow a similar pattern.
Understanding Annuities Due
What is an annuity due?
An annuity due, on the other hand, pays out at the start of a period. Common examples include rent payments and subscription fees for services such as Netflix and Amazon Prime. You make these payments before the service period begins.
Key Distinctions
Ordinary Annunity versus Annuity Due: What Sets Them Apart?
The primary distinction between an ordinary annuity and an annuity due lies in the timing of payments and how it affects the annuity's present value. Payment timing is crucial because it influences how valuable a future stream of payments is today.
When calculating the present value of any annuity, you'll find that the result is always less than the sum of the payments due to the time value of money. In other words, the cash promised for the future is less valuable than cash you possess now.
Why is this? Because you may invest the money to grow your wealth, which you cannot do with cash that has been promised. Present value formulas take this into account by accounting for the interest rate.
Ordinary Annuity vs. Annuity Due: Present Value Formulas
The present value formulas are similar for both annuity types; however, the calculations differ slightly because of the timing of payments.
For an ordinary annuity, the formula is:
[PV = R \times \frac{1 - (1 + r)^-n}{r} ]
where:- (R) is the amount paid regularly.- (r) is the annual interest rate.- (n) is the number of payments.
For an annuity due, the formula adjusts to:
[PV = R \times \frac{1 - (1 + r)^-n}{r} \times (1 + r) ]
The factor ( (1 + r) ) increases the present value for annuities due, making it higher than the ordinary annuity present value when all elements are equal.
Investing Tips
Which is Better: Ordinary Annuity or Annuity Due?
Your preference between an ordinary annuity and an annuity due depends on whether you are paying or receiving the annuity payments.
If you are the payer, you will generally find annuities due less advantageous because you will be forfeiting the use of your funds for a more extended period or missing out on the opportunity to generate income through your earnings.
On the flip side, if you are the recipient of the annuity income, you may prefer an annuity due because you will receive the money sooner.
FAQ
What is the Difference between an Ordinary Annuity and an Annuity Due?
The major difference between an ordinary annuity and an annuity due is the timing of the payments.
Which are the Four Types of Annuities?
The main types of annuities are immediate, deferred, fixed, and variable. Immediate annuities generate income right after purchase, while deferred annuities start paying in the future. Fixed annuities provide income based on a fixed interest rate, and variable annuities produce income based on the performance of investment funds.
Which Annuity is an Example of an Ordinary Annuity?
Mortgages and car loans are examples of ordinary annuities.
Sources:[1] Investopedia[2] Annuity.org[3] U.S. Securities and Exchange Commission
In the context of managing finances, investing in a traditional mortgage or a car loan is similar to an ordinary annuity because payments are made at the end of the applicable period, reflecting the time that has already passed. On the other hand, subscription fees for services like Netflix and Amazon Prime can be considered as examples of annuities due, as payments are made at the start of the service period.
