An annuity is a series of payments made or received over a predetermined period of time. The timing of those payments differs based on the type of annuity at hand. You can learn more about annuities from your broker, but today let's look at ordinary annuities and compare them with annuities due.
With an ordinary annuity, payments are made at the end of a covered term. Ordinary annuity payments are usually made monthly, quarterly, semiannually, or annually. A home mortgage, for example, is a common type of ordinary annuity. When a homeowner makes a mortgage payment, it typically covers the month-long period leading up to the payment date. Two other common examples of ordinary annuities are interest payments from bonds and stock dividends. When a bond issuer makes interest payments, which generally happens twice a year, the interest is paid and received at the end of the period in question. Similarly, when a company pays dividends, which typically happens quarterly, it is paying at the end of the period during which it retained enough excess earnings to share its proceeds with its shareholders.
With an annuity due, payments are made immediately, or at the beginning of a covered term rather than at the end. A rent or lease agreement, for instance, is a common example of an annuity due. When a rental or lease payment is made, it typically covers the month-long period following the payment date. Insurance premiums are another example of an annuity due, as payments are made at the beginning of a period for coverage lasting through the end of that period.
Differences in present value
Since payments are made sooner with an annuity due than with an ordinary annuity, an annuity due typically has a higher present value than an ordinary annuity. When interest rates go up, the value of an ordinary annuity goes down. On the other hand, when interest rates fall, the value of an ordinary annuity goes up. This is due to the concept known as the time value of money, which states that money available today is worth more than the same amount in the future because it has the potential to generate a return and grow. Put another way, $500 today is worth more than $500 one year from now.
If you're liable for making payments on an annuity, you'll benefit from having an ordinary annuity because it allows you to hold onto your money for a longer amount of time. However, if you're on the receiving end of annuity payments, you'll benefit from having an annuity due, as you'll receive your payment sooner.
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