Annuity; you’ve probably heard this word more than a few times but do you really know what it means? More importantly, how do you decide if an annuity is reasonable for any payments you are making and is there a way to make it more bearable if you are on a budget? This post is a beginner’s guide to annuity payments so you can effectively discuss with a finance person and not feel like your head is in the clouds.
At its most basic, an annuity is defined as fixed payments made in regular intervals. You’ve encountered annuities when talking about loan payments, your mortgage, your life insurance premium payments, and many other financial transactions. The best way to understand annuity for people with no prior background in finance is to look at it as broken up transactions of a lump sum of money. Essentially, instead of paying one big sum for your car purchase, you’re breaking it into monthly payments and that becomes your annuity.
Now, the tricky part to remember here is that when you total the annuities, the sum that you will get is always larger than the initial sum that you were planning to pay off. Say your mortgage costs $150,000 when paid at one-time; if you pay it in annuities, the total sum that you will end up paying over the life of the mortgage will probably be closer to $250,000.
This is because annuities factor “interest rates” into the calculation. Interest rates are known as the “future value of money” and are used to project how much a present amount will cost in the future. Look at it this way; a dollar today will never be able to buy the same things as a dollar ten years from now because of inflation and other factors. This is the same concept that is captured in annuities.
To get the most favorable annuity for any payment you are making, you need to look at two factors. First, how can you get a lower interest rate so the difference between the lump sum and total annuity payments down the road is not that big? Second, can you shorten the total payment duration for your annuities so the total sum (and also the interest rate) is lower?
Consider thinking along these lines when getting an annuity. It’s not enough that you only look at the amount you will be paying per month. If you are paying $10,000 per year over 10 years versus $8,600 per year over 15 years, then you have a more favorable annuity with the former than the latter.
Annuities may be technical terms in finance but it helps to be acquainted with it. You know you are bound to be paying annuities in one form or another down the road – or maybe you’re already doing it now. Educating yourself will help you appreciate your payments more and will put you in the best position to evaluate and come into a sound decision for your personal financial health.