Ordinary Annuity
What Is an Ordinary Annuity?
An ordinary annuity is a series of equivalent payments made toward the finish of successive periods over a fixed time span. While the payments in an ordinary annuity can be made as often as possible as each week, in practice they are generally made month to month, quarterly, semi-every year, or yearly. Something contrary to an ordinary annuity is an annuity due, in which payments are made toward the beginning of every period. These two series of payments are not equivalent to the financial product known as an annuity, however they are connected.
How an Ordinary Annuity Works
Instances of ordinary annuities are interest payments from bonds, which are generally made semiannually, and quarterly dividends from a stock that has kept up with stable payout levels for a really long time. The present value of an ordinary annuity is to a great extent dependent on the overall interest rate.
Due to the time value of money, rising interest rates reduce the current value of an ordinary annuity, while declining interest rates increase its current value. This is on the grounds that the value of the annuity depends on the return your money could earn somewhere else. In the event that you can get a higher interest rate elsewhere, the value of the annuity being referred to goes down.
Present Value of an Ordinary Annuity Example
The current value formula for an ordinary annuity considers three factors. They are as per the following:
- PMT = the period cash payment
- r = the interest rate per period
- n = the total number of periods
Given these factors, the current value of an ordinary annuity is:
- Present Value = PMT x ((1 - (1 + r) ^ - n )/r)
For instance, assuming an ordinary annuity pays $50,000 each year for a considerable length of time and the interest rate is 7%, the current value would be:
- Present Value = $50,000 x ((1 - (1 + 0.07) ^ - 5)/0.07) = $205,010
An ordinary annuity will have a lower present value than an annuity due, all else being equivalent.
Present Value of an Annuity Due Example
Review that with an ordinary annuity, the investor gets the payment toward the finish of the time span. That stands rather than a annuity due, in which the investor gets the payment toward the beginning of the period. A common model is rent, where the renter ordinarily pays the landlord in advance for the month ahead. This difference in payment timing influences the value of the annuity. The formula for an annuity due is as per the following:
- Present Value of Annuity Due = PMT + PMT x ((1 - (1 + r) ^ - (n-1)/r)
On the off chance that the annuity in the above model was rather an annuity due, its current value would be calculated as:
- Present Value of Annuity Due = $50,000 + $50,000 x ((1 - (1 + 0.07) ^ - (5-1)/0.07) = $219,360.
All else being equivalent, an annuity due is dependably worth in excess of an ordinary annuity, on the grounds that the money is received before.
Features
- An ordinary annuity is a series of standard payments made toward the finish of every period, like month to month or quarterly.
- Predictable quarterly stock dividends are one illustration of an ordinary annuity; month to month rent is an illustration of an annuity due.
- In an annuity due, conversely, payments are made toward the beginning of every period.
