An annuity describes a contract between a policyholder and an insurance company. With this contract, policyholders give the insurance company a lump-sum payment in exchange for a series of payments made instantly or at a set time in the future. There are different types of annuities that people should both know about and understand. An ordinary annuity means you are paid at the end of your covered term; an annuity due pays you at the beginning of a covered term. If you have an annuity or are considering buying annuities, here’s what you need to know about an ordinary annuity vs. an annuity due.
Consider working with a financial advisor as you sort through the pros and cons of an annuity due vs. an ordinary annuity.
What Is an Ordinary Annuity?
To understand an ordinary annuity, you should first understand what an annuity is not. Unlike buying stocks or bonds or funds, buying an annuity means buying an insurance policy – not buying securities. Specifically, an annuity is a contract to guarantee a series of structured payments over time. It starts at a predetermined date and lasts for a predetermined time.
It’s a payment against a larger obligation. For example, a cable bill is not, but a car payment or student loan payment is. Additionally, each payment in an annuity is the same, and each payment period is fixed to the same interval. For example, many retirement products are annuities that pay out fixed sums each month in retirement.
Therefore, an ordinary annuity makes its payment at the end of each payment period or interval period. For example, if an annuity has monthly intervals, it will make payments at the end of each month. Examples include mortgages paid at the end of the month, income annuities and dividend payments, which are usually made at the end of each quarter.
What Is an Annuity Due?
Now that you know the basics of an annuity and how an ordinary annuity works, you should know about an annuity due. An annuity due is paid at the beginning of each interval period. One example of an annuity due is a rent payment because it is made at the beginning of the month rather than the end. Other examples include insurance premiums and car lease payments.
Key Differences: Ordinary Annuity vs. Annuity Due
There are several key differences between an ordinary annuity and an annuity due. Some of the most notable differences are how they pay out and how they are valued. Here is a breakdown of the differences between ordinary annuities and annuities due:
The most notable difference in ordinary annuities and annuities due is the way they pay out. All annuities make a payment once per period, just like how bills are due during each billing cycle. The payments come at the end of the period or the beginning. With ordinary annuities, the payments come at the end of each payment period. With annuities due, the payment comes at the beginning. In general, loan payments are made at the end of a cycle and are ordinary annuities. In contrast, insurance premiums are typically due at the beginning of a billing cycle and are annuities due.
The present value of an annuity is the cash value of all your future annuity payments and is based on the time value of money. The time value of money is the concept that a dollar today is worth more than a dollar at the end of the year due to inflation. When comparing annuities, it is essential to remember that the length of a billing cycle can have a significant impact on the present value of the annuity. As a consumer, you can ask your lender or investment advisor to show you an annuity schedule.
What It Changes
Lenders and investment firms will calculate annuities. As a consumer, you have access to the annuity calculations as they are used to calculate how much you are charged. If you make your payment at the end of a billing cycle, your payment will likely be larger than if your payment is due immediately due to interest accrual.
Which Annuity Is Best?
In general, an ordinary annuity is most advantageous for consumers when they are making payments. Conversely, an annuity due is most advantageous for people when they are collecting payments. The payments made on an annuity due have a higher present value than an ordinary annuity due to inflation and the time value of money.
Besides the question of making or collecting payments, interest rates are a factor in evaluating annuities. When interest rates rise, the value of an ordinary annuity goes down; likewise, when interest rates fall, the value of an ordinary annuity goes up. In other words, $100 today is worth more than $100 one year from now.
An ordinary annuity is when a payment is made at the end of a period. An annuity due is when a payment is due at the beginning of a period. While the difference may seem meager, it can make a significant impact on your overall savings or debt payments. Keep in mind that an annuity – which is not an investment but rather an insurance product – may not be suitable for everyone. As you plan for retirement, it’s important to learn the pros and cons of annuities.
- Navigating the complex rules around annuities and other sources of retirement income can be difficult. That’s where a financial advisor’s expertise and guidance is so valuable. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Before making a decision about annuities, get a clear picture on how much you’ll need in retirement and how you’re doing in moving toward that goal. A free retirement calculator will provide you with the information you need.
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