Most of us have had the experience of making a series of fixed payments over a period of time鈥攕uch as rent or car payments鈥攐r receiving a series of payments for a period of time, such as interest from a bond or certificate of deposit (CD). These recurring or ongoing payments are technically referred to as "annuities" (not to be confused with the financial product called an annuity, though the two are related).
There are several ways to measure the cost of making such payments or what they're ultimately worth. Here's what you need to know about calculating the present value (PV) or future value (FV) of an annuity.
- Recurring payments, such as the rent on an apartment or interest on a bond, are sometimes referred to as "annuities."
- In ordinary annuities, payments are made at the end of each period. With annuities due, they're made at the beginning of the period.
- The future value of an annuity is the total value of payments at a specific point in time.
- The present value is how much money would be required now to produce those future payments.
Two Types of Annuities
Annuities, in this sense of the word, break down into two basic types: ordinary annuities and annuities due.
- Ordinary annuities: An ordinary annuity makes (or requires) payments at the end of each period. For example, bonds generally pay interest at the end of every six months.
- Annuities due: With an annuity due, by contrast, payments come at the beginning of each period. Rent, which landlords typically require at the beginning of each month, is a common example.
You can calculate the present or future value for an ordinary annuity or an annuity due using the following formulas.
Calculating the Future Value of an Ordinary Annuity
Future value (FV) is a measure of how much a series of regular payments will be worth at some point in the future, given a specified interest rate. So, for example, if you plan to invest a certain amount each month or year, it will tell you how much you'll have accumulated as of a future date. If you are making regular payments on a loan, the future value is useful in determining the total cost of the loan.
Consider, for example, a series of five $1,000 payments made at regular intervals.
Because of the time value of money鈥攖he concept that any given sum is worth more now than it will be in the future because it can be invested in the meantime鈥攖he first $1,000 payment is worth more than the second, and so on. So, let's assume that you invest $1,000 every year for the next five years, at 5% interest. Below is how much you would have at the end of the five-year period.
Rather than calculating each payment individually and then adding them all up, however, you can use the following formula, which will tell you how much money you'd have in the end:
Using the example above, here's how it would work:
Note that the one-cent difference in these results, $5,525.64 vs. $5,525.63, is due to rounding in the first calculation.
Calculating the Present Value of an Ordinary Annuity
In contrast to the future value calculation, a present value (PV) calculation tells you how much money would be required now to produce a series of payments in the future, again assuming a set interest rate.
Using the same example of five $1,000 payments made over a period of five years, here is how a present value calculation would look. It shows that $4,329.58, invested at 5% interest, would be sufficient to produce those five $1,000 payments.
This is the applicable formula:
If we plug the same numbers as above into the equation, here is the result:
Calculating the Future Value of an Annuity Due
鈥婞/strong>An annuity due, you may recall, differs from an ordinary annuity in that the annuity due's payments are made at the beginning, rather than the end, of each period.
To account for payments occurring at the beginning of each period, it requires a slight modification to the formula used to calculate the future value of an ordinary annuity and results in higher values, as shown below.
The reason the values are higher is that payments made at the beginning of the period have more time to earn interest. For example, if the $1,000 was invested on January聽1 rather than January 31 it would have an additional month to grow.
The formula for the future value of an annuity due is as follows:
Here, we use the same numbers, as in our previous examples:
Again, please note that the one-cent difference in these results, $5,801.92 vs. $5,801.91, is due to rounding in the first calculation.
Calculating the Present Value of an Annuity Due
Similarly, the formula for calculating the present value of an annuity due takes into account the fact that payments are made at the beginning rather than the end of each period.
For example, you could use this formula to calculate the present value of your future rent payments as specified in your lease. Let's say you pay $1,000 a month in rent. Below, we can see what the next five months would cost you, in terms of present value, assuming you kept your money in an account earning 5% interest.
This is the formula for calculating the present value of an annuity due:
So, in this example:
Present Value of an Annuity
The Bottom Line
The formulas described above make it possible鈥攁nd relatively easy, if you don't mind the math鈥攖o determine the present or future value of either an ordinary annuity or an annuity due. Financial calculators (you can find them online) also have the ability to calculate these for you with the correct inputs.