Expenses and liabilities drive the economies of small households and big conglomerates alike. The need to maintain expenses toward high-cost items such as housing and transport are basic and non-negotiable in today’s age. A tedious aspect of maintaining these expenses and liabilities is the sheer volume of debt or instalment payments we have to make towards them.
The cost of living in the new century might skyrocket every decade, but the sophistication with which small fixed payments towards large expenses have made their way into our lifestyle is glaringly evident. Rushing after due dates, interest rates, and online transactions have become a part of everyday living. We are systematically habituated towards making small payments such as rent or car loan instalments.
Since most of us are familiar with the practice of making fixed payments toward various types of expenses on a recurrent basis, there is a term for the same and it is called ‘annuities’. The payments that are called annuities are the backbone of our financial expenditure patterns and also shape the monetary corpus we’ll have in the foreseeable future. Since these expenses are dispersed over a long period of time, one might have trouble in understanding how much they actually end up costing in the long run. This oversight can be detrimental to your finances in the future, which is why the practice of calculating annuity is important.
Key Takeaways
- Annuities are payments that are made on a regular basis, such as rent on an apartment or interest on a bond.
- Payments are made at the conclusion of each period in ordinary annuities. Annuities due, however, are expected to be paid off at the beginning of the payment term.
- The total sum and penultimate worth of payments compiled at certain moment in time is called the future value of annuity.
- The present value is the amount of money needed right now to make those future payments.
Calculating Annuities: What are Ordinary and Annuities Due?
For calculating annuities, it is important to understand the basics and types of annuities. We can demarcate annuities into two different types: ordinary annuities and annuities due.
- Ordinary Annuities: An ordinary annuity requires the payments to be made after the term/time period has ended. For example, Bonds typically pay interest once every six months.
- Annuities Due: Payments for an annuity due, on the other hand, are made at the start of each term. Rental payments are an example of annuities due as they are traditionally paid at the beginning of each month.
Calculating Future Value of Annuity Formula
The foremost thing to consider when starting to make recurrent payments toward an expense is how much the total cost would be in the future. The cost can be calculated over an interest rate. The use of this practice will help identify the complete costs of major expenses over a long period of time and of they are feasible.
An example of the same can be calculating annuity toward an investment plan, which can help derive the complete investment return that one can expect after the completion of payments. It is also useful for a loan, as the future value calculated over the interest can show how much the loan cost as a whole.
To calculate annuity and deduce the future value of an investment plan the cost of a loan can be done through a future value of annuity formula as shown below:
So for example if you were to calculate the future value of an investment plan where you invest Rs 1,000 every year for five years at an interest rate of 5% then the amount below is how much you would accumulate at the end of the investment period
Future Value = Rs 1,000 x 5.53
= Rs 5,523.63
Calculate Present Value of Annuity Formula
A present value (PV) calculation, as a contrast to a future value calculation, informs you how much money you’ll need today to make a series of payments in the future, assuming the same interest rate.
Using the same amount of Rs 1,000 and an investment period of once every 5 years over an interest rate of 5% can help us check if our corpus will be enough to fulfil the 5 Rs 1,000 payments.
if we were to replace the required fields with the cash flow period, interest rate and number of payments:
= Rs 1,000 x 4.33
= Rs 4,329.48
Deducing the Future Value of an Annuity Due
Unlike ordinary annuity, annuity due requires payments to be made at the beginning of each period. Since this differs from the orientation of future value calculation for ordinary annuity, the formula gets a slight modification.
One might notice that the modification also leads to the amounts being higher in value. This is due to the payment point being at the beginning of the period, which allows it more time to grow. For example if Rs 1,000 was invested on January 1 instead of January 31, it would have an extra month to grow.
therefore, the future value for an annuity due can be calculated from
Replacing the fields with the corresponding amounts and numbers we get,
= 1,000 x 5.53 x 1.05
= Rs 5,801.91
Deducing the Present Value of an Annuity Due
Calculating annuity and present value for an annuity due also takes into account that the payments are made at the beginning of the time period. This can help you calculate the present value of rent deposits for the next five months, where you have personal funds in an account that increase over an interest of 5%
the present value of the rent payments to be made would be,
= 1,000 x 4.33 x 1.05
= Rs 4,545.95
The main goal in calculating annuity and using an annuity formula is to be able to predict your finances and requirements in a more cohesive and approachable manner. Maintaining recurrent payments can get tedious, and one might become passive to unnecessary and unprepared expenses if they do not precede their annuity payments with a basic calculation of the funds they have and the corpus they will have once their investments are matured.
Using an online future value of annuity calculator can help in streamlining your financial visibility. These online calculators with built-in features like present value of annuity formula, future value of annuity formula and present value of annuity formula.
Did You Know
The time value of money is used to calculate the present value of an annuity. Because of today’s unpredictable economic conditions, payments scheduled for decades in the future are worth less now. Current payments, on the other hand, are more valuable since they can be invested in the meanwhile.
Conclusion
While math can be intimidating, especially in the form of sophisticated equations; they are mostly here to simplify multiple variables and arrive at a singular answer. Since there are multiple variables in annuity payments, it can become cumbersome calculating annuity across different values. But the aforementioned formulas can make it easily possible to manage the chaos of recurrent payments, and help you establish a strong financial plan for the future.
Word to Remember
Annuity Table: This is a tool that is used to calculate the present value of an annuity. It is often called a present value table.
FAQs
Annuities are payments that are made on a regular basis, such as rent on an apartment or interest on a bond.
An ordinary annuity requires the payments to be made after the term/time period has ended. For example, Bonds typically pay interest once every six months.
Payments for an annuity due, on the other hand, are made at the start of each term. Rental payments are an example of annuities due as they are traditionally paid at the beginning of each month.
The foremost thing to consider when starting to make recurrent payments toward an expense is how much the total cost would be in the future. The cost can be calculated over an interest rate. The use of this practice will help identify the complete costs of major expenses over a long period of time and of they are feasible.
Calculating annuity toward an investment plan, which can help derive the complete investment return that one can expect after the completion of payments. It is also useful for a loan, as the future value calculated over the interest can show how much the loan cost as a whole. To calculate annuity and deduce the future value of an investment plan the cost of a loan can be done through a future value of annuity formula as shown below:
Also Read: What is Guaranteed Annuity on Investment Simplified
