An annuity due is a type of investment or loan where payments are made at the beginning of each period. The time value of money is important in calculating the future value of an annuity due. An example shows that using an annuity due for a loan can save interest payments.
An annuity due is an annuity instrument where payments are made over a fixed period of time at the beginning of each period. This type of instrument can be an investment or a loan, depending on its purpose and who owns the annuity. Examples of annuities include savings accounts, insurance policies, home mortgages, and other similar investments. The key point of an annuity due is that the payments occur at the beginning of the period, which plays a significant role in the time value of money.
The concept of the time value of money demonstrates the effects of interest on money saved over a period of time. Banks and other financial institutions offer interest to individuals and businesses as a benefit to save money instead of spending it right away. This concept requires the present value of the initial investment, the payments added to the initial balance, the interest rate, and the duration of the investment. Using a basic time value calculation, the future value of money is calculated. This formula can also calculate the present value of an annuity due by using this formula in reverse.
For example, suppose the following: An investor places $10,000 United States dollars (USD) in a savings account with an interest rate of 5 percent. No additional payments are added to the opening balance and the money will stay in the account for 10 years. The investor will receive payments at the beginning of each year because the investment is an annuity due. Based on the formula, the annual payments will equal $1,233.38 USD. Instead, suppose the information is the same, but the investor uses an ordinary annuity, where payments are made at the end of each year. The investor will receive payments of $1,295.05 USD each year, increasing the return on investment by $61.67 USD each year. The difference relates to the interest lost by accepting payments at the beginning of each year instead of at the end, resulting in a loss of interest income.
While a due annuity seems unfavorable in terms of an other investment savings account, imagine if the payments were made on a mortgage or other loan. Using the same information from the previous example, investors would save $61.67 in interest payments by making loan payments at the beginning of each year instead of at the end. Over the 10-year loan period, an individual would save $616.70 in interest by using an annuity due. This money could be reinvested to earn additional interest and increase an individual’s wealth rather than decrease it.
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