Many of the most common financial arrangements are structured as annuities, including mortgage and rent payments, insurance premiums, retirement benefits -- even a salaried worker's pay. An annuity will be either an ordinary annuity or an annuity due. The difference lies in the timing of each payment relative to the period the payment covers.
In finance, an annuity is any series of equal payments that are made at regular intervals. Though the word "annuity" comes from the Latin for "yearly," the periods between payments in an annuity can be just about anything -- years, months, weeks; it doesn't matter as long as the interval is consistent. An annuity can also last for a short period -- say a few months -- or for decades.
With an ordinary annuity, the payment comes at the end of the covered term. The typical home mortgage is an example of an ordinary annuity. When you pay your mortgage on Sept. 1, for example, you're actually paying for the use of your home (and the use of the lender's money) for August. You'll pay for September on Oct. 1, and so on. Most annuities are ordinary annuities, which is why they're called "ordinary." Other common examples include interest payments from bonds and payments on installment loans.
In an annuity due, the payment comes at the beginning of the term. The most familiar application of the annuity due is rent. When you pay apartment rent on Sept. 1, you're paying for the use of the apartment in September. Unlike with a mortgage, when your first payment typically isn't due until after your first full month in the home, your first rent payment is due when you move in. Insurance premiums are another common example of an annuity due; you pay today for coverage in the future.
In general, if you're the one making the payments, you're better off with an ordinary annuity. If you're the one receiving the payments, you're better off with an annuity due. The reason lies in a basic principle of finance known as the "time value of money": Because of inflation and the ability to earn interest on invested or banked money, a sum of money today is worth more than the same sum in the future. The longer you can delay making your first fixed payment, the less that payment costs you. On the flip side, the earlier you can receive the first payment of an annuity, the more it's worth. Practically speaking, though, once an annuity begins, the cash flows occur on the same schedule, and there's little noticeable difference between an ordinary annuity and an annuity due.
- "Corporate Finance: The Core," Second Edition: Jonathan Berk and Peter DeMarzo
- David R. Frick & Co, CPA: Annuity Due vs Ordinary Annuity
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