What is an Annuity?

//What is an Annuity?
What is an Annuity? 2017-09-30T06:06:41+00:00

Definition: An annuity is a series of equal payments made at equal intervals during a period of time. In other words, it’s a system of making or receiving payments where the payment amount and time period between payments is equal.

What Does Annuity Mean?

What is the definition of annuity? Most investment and loans are set up as annuities to keep the terms simple. Let’s take a look at both of these examples.

Example

Many people play the lottery in hopes to cash in on the big jackpot. Unfortunately, most people don’t win it big, but an extremely small percentage of people do. After they win, they often have to make the choice whether to be paid in a lump sum or in an annuity. For example, a million dollar jackpot could be paid out immediately in one lump sum of $600,000 or in $5,000 monthly installments for 15 years.

This option takes the time value of money into consideration. Notice that neither option actually pays out a full $1,000,000. This is because over time money should earn interest. Thus, $600,000 today will equal $1,000,000 in the future after interest is added up over the years. The same is true for the annuity payments.

Loans are also set up as annuities. Sometimes people don’t think of them as annuities because they are not receiving the payments. Remember annuities are just agreements with equal payments and time intervals. When a business signs a loan with a bank, it agrees to make a payment each month for specific amount. The payments are due each month until the loan principle is paid off.

The bank determines the interest rate and the time value of money needed to recoup their principle and generate the adequate return on the loan.

Accounting for annuities can be simple or complicated depending on the agreement, payment terms, and compounding interest arrangement. The key thing to remember is that prevent value and future value tables are often needed to calculate terms without a financial calculator.

Examples in The News

“An annuity is a contract with an insurance company generally purchased for future income in retirement.” – Washington Post

Summary Definition

Define Annuities: Annuity means a regular payment stream of equal amounts over a stated period.