An annuity due is an annuity with a fixed payment occurring at the beginning of a payment interval. In contrast, the payment for an ordinary annuity occurs at the end of the interval. If you have an annuity you are paying into or annuity payments you are receiving, the main difference between these two types of annuities is when you will pay funds out or receive a payment. The timing of the payment affects the stream of payments, the present and future value calculations and your cash flow.
What Is an Annuity?
The term "annuity" refers to a series of fixed periodic payments or cash flows that are either received (inflows) or paid out (outflows) by an individual. Annuity payments are equal payments over a fixed period of time, although there may be exceptions to this pattern in certain annuity contracts. Both the ordinary annuity and annuity due are common types of annuities.
Annuities are often used as a means of retirement income. They are developed by life insurance companies and can be sold by insurance companies, financial planners and financial institutions. Fixed annuities guarantee the buyer a fixed rate of return on their contributions, while variable annuities have a fluctuating rate. Purchase rates vary, depending on the type of annuity.
Valuation of an Annuity
The present value of an annuity is the cash value of all future annuity payments. You'll need the following pieces of information to perform the present value calculation of an annuity:
- PMT = the payment amount or periodic cash flows
- r = the periodic interest rate or discount rate
- n = the total number of payments or number of periods for the annuity
Per the Corporate Finance Institute (CFI), the formula for present value (PV) of a regular annuity is: PV = PMT × 1/r × (1−(1+r)n)
If you have a financial calculator from Texas Instruments, you can follow their steps to determine present value. There are also present value calculators available online. The timing of annuity due payments and ordinary annuity payments differs, so the calculations and both their present and future values will differ, explains CFI.
What Is an Annuity Due?
When an annuity due is paid, the payment covers an interval after the payment is made. This leaves the annuity due to be commonly described as a payment occurring at the beginning of a period.
Any fixed payment for a service or property before a service period begins is an example of an annuity due payment. Typical applications include lease payments and insurance premiums.
When an Annuity Due Is Beneficial
Because annuity payments are due at the beginning of a period, if all else is equal, the present value of an annuity due is higher than the present value of an ordinary annuity. CFI explains that this is due to the time value of money principle since annuity due payments are received earlier. If you are collecting annuity payments, an annuity due is beneficial because of that higher present value.
What Is an Ordinary Annuity?
The payment on an ordinary annuity occurs at the end of a period. Most installment loans can be classified as ordinary annuities, as can the coupon payments associated with straight bonds. The payments are due at the end of the period. Mortgage payments due at the end of each month are an example of an ordinary annuity.
When an Ordinary Annuity Is Beneficial
Due to the payment occurring at the end of a period, an ordinary annuity is more beneficial when making payments. With payments due later, your cash flow is positively affected.
Annuity Due | Ordinary Annuity | |
|---|---|---|
| Payments due | At the start of the period | At the end of the period |
| Present value | Higher (Payments received earlier) | Lower (Payments received later) |
| Future value | Higher (Payments received earlier) | Lower (Payments received later) |
| Benefit you when | Receiving payments | Making payments |
| Examples | Rentals, leases, insurance premiums | Mortgages, loans, dividend payments |
FAQs About Annuity Due and Ordinary Annuity
What Is the Difference Between an Annuity and a Perpetuity?
A perpetuity is like an annuity that doesn't have an end date. Annuity payments are a series of payments received for a set period of time until a maturation date, while a perpetuity is a cash flow payment that continues indefinitely.
Rental properties and some preferred stocks are examples of perpetuities. As long as the real estate continues to exist and generate rent or the business exists and pays dividends, the investor continues to receive monthly returns.
Which Type of Annuity Is Best for Retirement Planning?
For individuals who plan to use annuities to supplement Social Security benefits or other pensions later in life, the ordinary annuity and annuity due offer different advantages. The first-of-the-month payment of the annuity due provides faster access to cash. It allows a retiree to immediately begin gaining interest on funds contributed before the disbursement period.
If you put funds in multiple annuities, you might opt for a mix of different types of annuities to receive funds at the beginning and end of the month to supplement any Social Security benefits or pension payments.
What Is the Difference Between an Annuity and Lump-Sum Payment?
Some annuities, such as pension plans, offer the choice of payout as a lump-sum payment or annuity payments. While annuities will pay out over time, lump-sum means you'll collect all of your money at once. The options for and IRS.https://www.irs.gov/taxtopics/tc412#:~:text=A%20lump%2Dsum%20distribution%20is,%2C%20or%20stock%20bonus%20plans).) tax implications of such retirement plans are best discussed with your financial adviser.
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