What Is an Annuity?
An annuity is a series of fixed, equal cash flows.
Annuity streams have three characteristics:
- Each payment in the series is the same
- The payments occur at equal intervals
- The payments occur over a finite period
Types of Annuities
There are two types of annuity streams: ordinary annuities and annuity dues. An ordinary annuity is a fixed payment stream where the payment occurs at the end of each period. An annuity due is a fixed payment stream where the payment occurs at the beginning of each period.
Why Annuities Matter in Finance
Many financial instruments are structured as annuity streams, so it is important for investors to familiarize themselves with these payment structures.
We can find the present value of an annuity stream by discounting the annuity payments. We can find the future value of an annuity stream by compounding the annuity payments. We can also find the other variables involved in annuity streams if given the necessary information.
Key questions involving annuity streams include:
- What is the monthly payment on a residential mortgage?
- What is the interest rate on a vehicle loan?
- What is the value of a bond with a fixed semiannual payment?
- What is the future value of a savings plan with fixed contributions?
Financial calculators and spreadsheet software programs have built in functions which make it easy to perform calculations involving annuities.
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Example of an Annuity
For example, suppose that a business owner wants to take out a $100,000 loan. Banks are currently charging an 8% average annual interest rate on such loans with an average loan term of four years. The business owner can estimate the monthly payments for this loan by entering the following inputs into a financial calculator or computer spreadsheet:
The payment on this loan is $2,027.64 per month.
Key Takeaways
- An annuity is a series of fixed, equal cash flows that occur at regular intervals.
- Each payment in an annuity stream is the same amount and occurs over a finite period.
- There are two main types of annuities: ordinary annuities and annuity dues.
- Many financial instruments such as mortgages, loans, and bonds are structured as annuity streams.
- Financial calculators and spreadsheet software are commonly used to calculate annuity payments and values.