What Is an Ordinary Annuity?
An ordinary annuity is a series of equal payments made at the end of consecutive periods over a fixed length of time. Ordinary annuities may be paid monthly, quarterly, semi-annually, or annually.
The opposite of an ordinary annuity is an annuity due, in which payments are made at the beginning of each period. A .rent payment is an annuity due. A mortgage payment is an ordinary annuity.
Neither an ordinary annuity nor an annuity due refers to the financial product known as an annuity, though they are related.
Key Takeaways
- An ordinary annuity is a series of regular payments made at the end of each period, such as a month or a quarter.
- In an annuity due, payments are made at the beginning of each period.
- Stock dividends and bond dividends are examples of ordinary annuities. A monthly rent payment is an example of an annuity due.
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How an Ordinary Annuity Works
An example of an ordinary annuity is the interest payment on a bond. These are generally made semiannually. Regular quarterly dividends from a stock that has maintained a stable payout level for years are another example.
The present value of an ordinary annuity is largely dependent on the prevailing interest rate.
Because of the time value of money, rising interest rates reduce the present value of an ordinary annuity, while declining interest rates increase its presentvalue. This is because the value of an annuity is based on the return your money could earn elsewhere. If you can get a higher interest ratesomewhere else, the value of the annuity goes down.
Present Value of an Ordinary Annuity Example
The present value formula for an ordinary annuity takes into account three variables. They are:
- PMT = the period cash payment
- r = the interest rate per period
- n = the total number of periods
Given these variables, the present value of an ordinary annuity is:
- Present Value = PMT x ((1 - (1 + r) ^ -n ) / r)
For example, if an ordinary annuity pays $50,000 per year for five years and the interest rate is 7%, the present 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 equal.
Present Value of an Annuity Due Example
An investor with an ordinary annuity receives the payment at the end of the agreed time period.
An alternative is an annuity due, in whichthe investor receives the payment at the beginning of the period. A common example is rent. The renter typically pays the landlord in advance for the month ahead.
This difference in payment timing affects the value of the annuity. The formula for an annuity due is as follows:
- Present Value of Annuity Due = PMT + PMT x ((1 - (1 + r) ^ -(n-1) / r)
If the annuity in the above example was instead an annuity due, its present 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 equal, an annuity due is worth more than an ordinary annuity because the money is received earlier.
Is an Ordinary Annuity Better Than an Annuity Due?
Generally, an annuity due is better for the party that is paying and not as good for the recipient. The recipient is paying up front for the period ahead. With an ordinary annuity, the payment is made at the end of the previous period. Money has a time value. The sooner a person gets paid, the more the money is worth.
What Is an Annuity?
The word annuity commonly refers to an insurance product purchased by an individual. In return for a lump-sum payment or a series of payments to the financial institution, the individual receives a steady stream of regular payments. The annuity is most often used as a source of retirement income.
What Are the Most Common Types of Ordinary Annuities?
The most common types of ordinary annuities are stock and bond dividends. These are paid at the end of each period of the agreement rather than at the beginning of the period. In the case of stock dividends, this is because the dividends are based on the company's profits for the immediate preceding period.
The Bottom Line
Ordinary annuity is a business term that describes any regular payment that is made at the end of a relevant cycle rather than at its start. If you have a dividend-paying stock or a bond, you have an ordinary annuity.
