Understanding Annuity Due vs. Ordinary Annuity: Key Differences and Benefits
Tue May 28 2024
byChase Ross
Introduction
The purpose of this article is to discuss the difference between an ordinary annuity and an annuity due. In sum the difference between the two is that once payments start an annuity due begins at the beginning of the payment period vs. the end of the payment period for an ordinary annuity. This article discusses the key terms and differences between these two financial products and discusses different examples of each. The discussion also turns towards the time value of money and why the payments at the end of a period vs the beginning can make a difference to the payer and the payee of the annuity.
Key Terms
Annuity Due: A financial product (rent, insurance premium, subscriptions, etc.) where equal payments to or from are made at the beginning of each period.
Ordinary Annuity: A financial product (mortgage, car payments, etc.) where equal payments to or from are made at the end of each period.
Arrears: Typically means a late payment or financial obligation past due, but in the example of a mortgage payment the first payment is in arrears, typically one month after someone has owned the home.
Time Value of Money: The concept of comparing the value of a dollar today vs. tomorrow. Or the value of a dollar today is worth more than the value of a dollar sometime in the future. This is due to the earning potential of a dollar in the present.
Present Value: The value, in the present, of a future dollar or sum of money received in the future. This value is dependent upon the discount rate used for the future cash flows.
Future Value: The value of a dollar, in the present, at a future time. Or, “The value of an asset at a specified date in the future.” This value will vary depending on several factors, one of which is the interest rate given.
Discount Rate: The rate used to “discount” future cash flows to determine a present value.
The Key Differences
The differences between an annuity due and ordinary annuity are tabulated below.
| Feature | Annuity Due | Ordinary Annuity |
|---|---|---|
| Payments Received/Paid | Beginning of period | End of period |
| Present Value | Higher present value since payments are made at the beginning of the period | Lower present value due to discounted future cash flow |
| Future Value | Lower future value since there is less time to accrue interest or compound | Higher future value given the time to earn interest or compound |
| Interest Accrual (payee) | Less interest accrued due to immediate payment | More interest accrued due to payment at end of period, more time to compound |
| Examples | Rent, insurance premiums, subscriptions | Mortgage, car loans, other loans |
Present/Future Value Formulas
For time value calculations for annuity due and ordinary annuities click here and here and here.
The important thing to remember is that in general an annuity due is worth more than an ordinary annuity because the payment is received at the beginning of the period (for payee).
So, which is better?
The answer to that question depends on whether you are the payer or the payee. As the one receiving payment you may prefer the money up front (annuity due) to either use the funds immediately. As a payer, you may prefer to pay at the end of the period (ordinary annuity) to be able to allow the money to accrue interest prior to having to use the funds for the payment. The other consideration is risk. As an insurance company or subscription service provider or landlord, you would prefer the money up front or at the beginning of the period (annuity due). This cash on hand reduces the risk of missing payroll or going into debt if the financial obligations owed to you in the future are not paid (or a claim is made in the case of an insurance company).
Conclusion
Personal finances are just that – personal. Everyone is different with different circumstances. Although the difference between an annuity due and an ordinary annuity boils down to timing of the payment, which you prefer will depend on the factors discussed above.
The other takeaway from this is the concept of the time value of money. This is a key concept for personal finance since it affects many aspects of our lives: our homes, cars, insurance, investments, savings, etc. As the name suggests, the concept highlights how the value of money changes over time. Examples could be the effect of inflation on an annuity or potential investment growth of a retirement portfolio. This concept will enable you to make informed decisions about saving, investing, safe withdrawals, etc. Thus, ensuring your money works efficiently and effectively towards long term goals.
When it comes to annuities this knowledge will help in evaluating the present and future value of payments, helping you determine which product will best fit your personal needs and goals. This will ensure a secure, stable and sufficient income stream in retirement.