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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. Annuity examples include savings accounts, insurance policies, home mortgages and other similar investments. The key point of an annuity due is that payments occur at the beginning of the period, which plays a significant role in the time value of money concept.
The time value of money concept demonstrates the effects of interest on money saved over a period of time. Banks and other financial institutions offer individuals and businesses interest as a benefit for saving money rather than spending it right away. This concept requires the present value of the initial investment, payments added to the initial balance, interest rate, and length of investment. Using a basic time value calculation, the future value of the money is calculated. This formula can also calculate the present value of an annuity due using this formula in reverse.
For example, assume the following: an investor places $10,000 US Dollars (USD) in a savings account with a 5 percent interest rate. No additional payments are added to the initial balance and the money will remain 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. In contrast, assume 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 taking payments at the beginning of each year rather than the end, resulting in a loss of interest income.
While an annuity due seems unfavorable in terms of a savings account of other investment, imagine if the payments were made to a mortgage or other loan. Using the same information from the above example, investors would save $61.67 USD in interest payments by making loan payments at the beginning of each year rather than at the end. Over the 10 year loan period, an individual would save $616.70 USD in interest by using an annuity due. This money could be reinvested to earn additional interest and add to an individual’s wealth rather than decreasing it.