What is Annuity? - Definition & Formula

An error occurred trying to load this video.

Try refreshing the page, or contact customer support.

Coming up next: What Is Business Analysis? - Process, Methods & Example

You're on a roll. Keep up the good work!

Take Quiz Watch Next Lesson
Your next lesson will play in 10 seconds
  • 0:00 What Is an Annuity?
  • 0:27 Examples of Annuity
  • 1:14 The Value of Annuities
  • 2:37 The Formula
  • 3:44 Lesson Summary
Save Save Save

Want to watch this again later?

Log in or sign up to add this lesson to a Custom Course.

Log in or Sign up

Speed Speed

Recommended Lessons and Courses for You

Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

In this lesson, you'll learn about payments that occur at regular time intervals, or in financial terms, annuities. Afterwards, test your understanding of the lesson with a quiz.

What Is an Annuity?

If you're ever lucky enough to win any substantial amount in the lottery, you'll have two choices: take a lump sum now or take payments over a certain number years. An annuity is simply a series of future cash payments that occur at a regular interval. The payments can be different amounts, but must occur regularly - usually monthly, quarterly, or annually.

Examples of Annuity

There aren't a lot of people who experience annuities through lottery winnings that pay out millions of dollars per year, but many people are familiar with another type of annuity - a mortgage payment. A mortgage payment is a regularly occurring series of payments, or annuity, on a real estate loan. These people aren't on the receiving end of the annuity - the bank is.

Some other examples of annuities include life insurance payments, pension payments, regular savings account deposits, and some investments. Financial institutions will sometimes sell annuities, so in exchange for either a one-time payment or a series of payments, the bank will give you your money back, plus interest, at some future time.

The Value of Annuities

If you have an annuity that pays you $1,000 per year for ten years, what is the value - right now - of your annuity? The answer isn't $10,000 as many people might calculate. Instead, calculating the value of an annuity involves a financial concept called the time value of money. Essentially, the idea of the time value of money is simply that money loses its value over time. For example, fifty years ago, you could buy a candy bar for a nickel; now it costs over a dollar. This is due to inflation, during which prices rise and money loses its value. The faster prices rise, the less your future money is worth.

Because money loses its value over time, the actual value of an annuity depends on the interest rate. Interest rates are what determines if $1,000 in ten years can buy the latest tablet computer or a candy bar. When valuing an annuity, you need to select an interest rate. If you are simply trying to save your money and don't want to lose purchasing power, then all you need to do is use the expected inflation rate as your interest rate. If you want to make a 10% return on your money, you need to discount the annuity at 10%.

The Formula

The formula for calculating the present value of an annuity - the value today of a stream of future payments - is the same whether the payments are the same amount each period or if they vary.

To unlock this lesson you must be a Study.com Member.
Create your account

Register to view this lesson

Are you a student or a teacher?

Unlock Your Education

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back
What teachers are saying about Study.com
Try it now

Earning College Credit

Did you know… We have over 220 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Used by over 30 million students worldwide
Create an account