What is Ordinary Annuity?
What is the primary difference between an ordinary annuity and an annuity due?
What are the essential elements you should know!
In this article, we will break down the notion of Ordinary Annuity so you know all there is to know about it!
Keep reading as we have gathered exactly the information that you need!
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Table of Contents
What Is An Ordinary Annuity
An “ordinary annuity” refers to a series of payments made over a fixed period of time at the end of a consecutive period.
Annuity payments can be:
- Annual payments
- Semi-annual payments
- Quarterly payments
- Monthly payments
- Bi-weekly payments
- Weekly payments
There are essentially two types of annuities:
- Ordinary annuity
- Annuity due
We are all familiar with having to make or receive a series of payments over time.
For instance, an investor may receive a series of quarterly dividends by investing in a “blue chip” stock or getting semi-annual interest payments on a certificate of deposit (CD).
When the payment is made on a financial product at the “end” of a defined period, we refer to payments as ordinary annuity.
We are also familiar with rent payments where a tenant pays the rent at the beginning of the month.
When the payment is made at the beginning of a defined period, we refer to that payment as annuity dues.
Ordinary Annuity Formula
The value of the entire ordinary annuity payment can be calculated by assessing its present value.
In essence, when considering the time value of money, an investor or annuity beneficiary can expect the present value of its annuity payments to increase or decrease as the market interest rates fluctuate.
When interest rates decline, the present value of the annuity payments goes up.
When interest rates go up, the present value of the annuity payments goes down.
The present value of an ordinary annuity can be calculated based on the following formula:
Present Value = Payment X ((1 – (1 + Rate of Interest Per Period) ^ – Total Number of Periods) / Rate of Interest Per Period)
Here is a short version of formula to calculate the PV of ordinary annuity:
P = PMT [(1 – (1 / (1 + r)n)) / r]
P = Present Value
PMT = Annuity Payment
r = Interest rate
n = Number of periods
Ordinary Annuity vs Annuity Due
What is the difference between annuity due vs ordinary annuity?
An ordinary annuity represents regular payments made at the end of a defined period.
For example, you can have an annuity payment made at the end of each calendar month.
On the other hand, an annuity due is the opposite of ordinary annuity.
In essence, with annuity due, the payments are made at the “beginning” of each payment period.
For example, you can have payments made at the start of each calendar month.
There are key differences between ordinary annuity and annuity due, such as:
- The payouts
- The present value
An “annuity” payment is typically paid once per period.
When the annuity payment is made at the end of the period, it’s “ordinary” and when it’s at the beginning, it’s “due”.
Another notable difference between an ordinary annuity and an annuity due is how it is valued.
You can calculate the present value of an annuity based on the time value of money concept.
Money today is worth more than money tomorrow particularly due to inflation and the loss of purchasing power over time.
When calculating the PV of annuities, it’s important to keep in mind the period to ensure that you calculate the present value correctly.
Ordinary Annuity Examples
Let’s look at a few examples to better understand the concept of ordinary annuities.
A great example of an ‘ordinary annuity’ is when a company pays quarterly dividends to its shareholders.
At the end of the quarter, the shareholders receive the dividend payment representing the annuity payment.
Another example would be interest payments made on bonds.
When a bondholder receives a semi-annual or yearly interest payment, it is receiving an “ordinary” annuity as it is getting the payment at the end of the defined period.
You can also find ordinary annuities in insurance products.
When a policyholder makes a lump-sum payment to an insurance company who in return offers the policyholder a series of payments at the end of a covered term, we refer to that as ordinary annuity.
Ordinary Annuities Takeaways
So what is the legal definition of Ordinary Annuity?
Let’s look at a summary of our findings.
Define Ordinary Annuity
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