What Is an Ordinary Annuity?

What Is an Ordinary Annuity?

Let me tell you directly: an ordinary annuity is a series of equal payments you make at the end of consecutive periods over a fixed length of time. These payments can be monthly, quarterly, semi-annually, or annually.

The opposite is an annuity due, where payments happen at the beginning of each period. Think of rent as an annuity due, while a mortgage payment is an ordinary annuity.

Remember, neither term refers to the actual financial product called an annuity, though they're related concepts.

Key Takeaways

You should know that an ordinary annuity means regular payments at the end of each period, like a month or quarter. In contrast, an annuity due pays at the start. Examples of ordinary annuities include stock dividends and bond interest, while monthly rent is an annuity due.

How an Ordinary Annuity Works

Consider how this functions: an example is the interest payment on a bond, typically made semiannually. Another is regular quarterly dividends from a stock with stable payouts over years.

The present value of an ordinary annuity depends heavily on the prevailing interest rate. Due to the time value of money, if interest rates rise, the present value drops; if they fall, it increases. This happens because the annuity's value ties to what your money could earn elsewhere—if higher rates are available, the annuity's value decreases.

Present Value of an Ordinary Annuity Example

The formula for present value uses three variables: PMT for the period cash payment, r for the interest rate per period, and n for the total number of periods.

So, the present value is PMT x ((1 - (1 + r) ^ -n ) / r). For instance, if an ordinary annuity pays $50,000 per year for five years at 7% interest, it's $50,000 x ((1 - (1 + 0.07) ^ -5) / 0.07) = $205,010.

Importantly, an ordinary annuity has a lower present value than an annuity due, assuming all else is equal.

Present Value of an Annuity Due Example

With an ordinary annuity, you receive payment at the end of the period. But an annuity due pays at the beginning, like rent paid in advance to the landlord.

This timing difference impacts value. The formula for annuity due is Present Value = PMT + PMT x ((1 - (1 + r) ^ -(n-1) / r). Using the same example, it would be $50,000 + $50,000 x ((1 - (1 + 0.07) ^ -(5-1) / 0.07) = $219,360.

All else equal, an annuity due is worth more because you get the money sooner.

Is an Ordinary Annuity Better Than an Annuity Due?

Generally, an annuity due benefits the payer more and the recipient less, since payment is upfront for the period ahead. With an ordinary annuity, it's at the end of the previous period. Money's time value means earlier receipt increases its worth.

What Is an Annuity?

The term annuity often means an insurance product you buy with a lump sum or payments, getting steady regular payments back—commonly for retirement income.

What Are the Most Common Types of Ordinary Annuities?

The most common are stock and bond dividends, paid at the end of the period, not the beginning, because they're based on the preceding period's profits.

The Bottom Line

An ordinary annuity is simply a regular payment made at the end of a cycle, not the start. If you hold dividend-paying stock or a bond, that's what you have.