Everything you wanted to know about Annuity Due

For example, landlords ask for rent payments during the initial days of the month as against collecting them at the end of the month.

How does Annuity Due work?

Initial payments are the central characteristic of an annuity due. Annuity due payments are analogous to assets when they are received by individuals in a legal way. At the same time, the annuity due paid to an individual is considered to be a legal debt liability, which requires regular interval payments. 

Both the sender and receiver of the annuity due payments need to calculate the total value (present and future), as they represent the cash inflows and outflows. One method to accomplish this is by deploying the use of present value calculations.

What is a Whole Annuity Due? 

This is a type of product marketed by insurance companies that mandate that payments of the annuity due are to be made at the beginning of each month or quarter or on a yearly basis. This form of annuity due offers the participant, a consistent distribution period for payments during the remainder of their natural lifetimes. When the annuitant expires, the insurance company retains the right to hold onto the remaining funds. In this context, it is important to know that all annuity income payments are considered ordinary income for taxation purposes.

Examples:

Recurring financial obligations are similar to annuity due payments. Utility payments such as mortgages, house rents, car EMI payments and even mobile network payments come under the category of an annuity due. The beneficiary is legally obligated to pay for the products or services at the initial stage of the billing period. Another example would be insurance expenses, as the insurance mandates that the payment of the insurance premium should be done at the beginning of every coverage period. Retirement savings and assignment of a fixed amount of money for a specific purpose come under the umbrella of annuity due payments.

Difference between Annuity and Annuity Due?

As discussed above, the prime difference between an ordinary annuity and annuity due focuses on the occurrence of payments.

Financial investment avenues where the individuals receive a fixed or variable payment from an insurance company every month are examples of ordinary annuities. Monthly payments which involve reckoning of interest on the account balance during the initial phase of the payment are examples of an ordinary annuity. The payments of ordinary annuity are dependent on the performance of your investment account.

When compared to the stock markets option, both ordinary annuity and annuity due bear the relative risk of underperformance. In certain cases, the returns that are expected from low-cost index funds are on the higher side with less probability of default when compared to financial annuity due instruments. It is recommended that individuals research the various parameters of Annuity due before making a financial commitment.

Present Value of Annuity Due

The present value of a series of cash flows can be considered as the present value of an annuity due. The payments that are derived from the annuity due are disbursed at the starting of each time period. To comprehend the present value of an annuity due, individuals should have a robust understanding of the two variants of an annuity. 

How the Present Value of an Annuity Due is Calculated?

The equation for computing the present value of an annuity due is: 

PV=C× [{1- (1+r) ^–n}/ r] × (1+r), where 

‘C’ indicates cash flow per time period

‘r’ indicates the rate of Interest

‘n’ indicates the number of periods

The central principle in finding the present value of an annuity due is that the immediacy of the payments. In calculating the present value, the interest rate terminology is substituted by the term discount rate. The interest rate can sometimes be a fluctuating variable when calculating the present value of an annuity due to the above formula. 

Annuity due payments can be given out at variable frequency such as monthly, annually and semi-annually. The variant of the interest rate that is used in the calculation should be equivalent to the number of payments that are being substituted in the equation. If individuals are receiving payments on a semi-annual basis, then it is only natural that the calculation equation of the present value of annuity due should also employ a semi-annual interest rate. 

An example would be the following. If annuitants are receiving monthly payments with the annual interest rate of return of 12%, then the formula to calculate the present value of an annuity due would use a monthly interest rate of 1%.

Let us consider the following case study:

Mr Prakash is servicing a business loan which requires payments of Rs 5000 each month beginning for a time period of 12 months. The annual rate of interest on the loan is 12%. In this example to calculate the present value of the annuity due, the annuitants need to identify the value and contextual meaning of the diverse variables. Firstly, the interest rate needs to be divided by 12 since even though the interest rate is compounded on an annual basis, the annuity due has monthly payments. Consequently, we use the value of the interest rate as 1% in the calculation.

Number of time periods= 12

Annuity payments in cash value for every time period = Rs 5000 

Rate of interest=0.01 

Using the above equation the present value of the annuity due for Mr Prakash would be Rs 5,838. This knowledge can help Mr Prakash to correctly understand the present value of an annuity due. Mr Prakash can now analyse how the interest charges charged would consequently affect his finances. The correct analysis of the present value of annuity due helps individuals to consider the cost versus benefit ratio of a loan. Individuals who have already availed of the loan can use the above formula to comprehend the urgency for immediate repayment at a faster rate to preclude the incidence of additional interest fees.

People also read: best pension plan in india

Future Value of an Annuity Due

This signifies the final value of a continuous series of probable payments for the entered value at a certain future date. The future value of an annuity due is deployed to analyse and compute the future value of payments in cases where the payments need to be urgently made at the starting of the payment period.

Prediction of the final result of a continuous series of payments over a particular period of time can be made using the below equation for the future value of an annuity due. 

FV=C×[ {(1+r) ⁿ-1)/r]×(1+r)

C = cash value that needs to be made at the starting of the payment period

r = interest rate

n = number of payments

In this context, the term ‘value’ indicates the probable cash flows that a group of future payments can achieve. Calculating the potential returns of an investment at a future date in time can be done using the future value of the annuity due.

Another Case Study:

Mr Prakash sees an advertisement for a two-bedroom house which is available on a rental basis of rupees 18000 per month. He wants to take out a rental lease for a time period of three years. The rent amount for the advertised house is rupees 9600 more than what he is presently paying on an annual basis. Before entering into a financial commitment, Mr Prakash wants to know how much money he will be receiving in the coming three years if he chooses to stay in his present home and invest the extra Rs 9600 per year in an interest-paying account at the rate of 5% annually. 

In the present case,

Number of payments= 3 

Cash value per period = 9600 

Rate of interest = 0.05

On applying the above formula and substituting the variables, the future value of the annuity due is calculated and it is found out that the final cash value of Mr Prakash’s investment over a time period of three years would be Rs 31,777. 

Analysis shows that this amount is a considerable investment if Mr Prakash chooses to stay in his present apartment for the coming 3 years. Using this knowledge, annuitants can take accurate financial decisions and weigh their life choices relative to their financial needs. In this case, it is important to know that the rate of interest is not altered throughout the series and the quantum of payments is equivalently distributed.

Difference between Present Value and Future Value of Annuity Due

The present value of an annuity due estimates the current value of an investment quantum that is due to start immediately which is dependent on future payments. In the present value of annuity due, all payments would be sent out during the starting period of every cycle. The payment frequency and the applied interest rate must match for the effective calculation of the present value of an annuity due.

The future value of an annuity due is a potent investigative tool for individuals to evaluate the cash flow probabilities on a specific financial investment. This is primarily deployed to find the future value of a series of annuities payment at a specified date, provided that the interest rate remains the same. 

The Final Verdict

Annuity Due is the payment that should be done at the beginning of the specified payment interval. This is in contrast to an ordinary annuity which creates payments at the final stages of the time period. Using this analogy, there are different mathematical methods for computing the future and present values of the annuity due. A simple example of an annuity due would be a series of house rent payments that need to be made to the house owner. Mortgage payments that are made to banks come under the category of ordinary annuity payments. The financial sagacity of selecting a type of annuity due depends on whether you are paying the funds or are in receipt of the funds.