Pamantasan ng Lungsod ng Maynila

Simple Annuities
(Ordinary Annuity, Annuity Due, and
Deferred Annuity)

PLM Business School-Department of Business Economics

COURSE CODE: MATHEMATICS OF INVESTMENT
1st Semester of A.Y. 2022-2023
 Introduction
• Let’s say you want to save money to go on a vacation, or you
want to save money now for your baby’s college education.
• A strategy for saving a little bit of money in the present and
having a big payoff in the future is called an annuity.
• An annuity is an account in which equal regular payments are
made.
• There are two basic questions with annuities:
– Determine how much money will accumulate over time given that
equal payments are made.
– Determine what periodic payments will be necessary to obtain a
specific amount in a given time period.
 Calculating short-term
annuities
• Claire wants to take a nice vacation trip, so she begins setting
aside $250 per month. If she deposits this money on the first of
each month in a savings account that pays 6% interest
compounded monthly, how much will she have at the end of 10
months?

• Claire’s first payment will earn 10 months interest. So F = 250(1

+ .06/12)12(10/12). Note that the time t is 10/12. Therefore F =
250(1.005)10 = $262.79.

• Claire’s second payment will earn 9 months interest. Thus F =

250(1.005)9 = $261.48.
 Table of future values
Payment Future Value
Totaling up the future value
1st 250(1.005)10 = $262.79
column, we see that Claire
2nd 250(1.005)9 = $261.48 has $2569.80 to use for her
3rd 250(1.005)8 = $260.18 vacation.
4th 250(1.005)7 = $258.88 She earned $69.80 in
5th 250(1.005)6 = $257.59 interest.
6th 250(1.005)5 = $256.31
7th 250(1.005)4 = $255.04
8th 250(1.005)3 = $253.77
9th 250(1.005)2 = $252.51
10th 250(1.005)1 = $251.25
 Ordinary Annuity and Annuity
Due
• There are two types of annuity formulas.
• One formula is based on the payments being made
at the end of the payment period. This called
ordinary annuity.

• The annuity due is when payments are made at the

beginning of the payment period.

• We will derive the ordinary annuity formula first.

 Calculating Long Term Annuities
• The previous example reflects what actually happens to an annuity.

• The problem is what if the annuity is for 30 years.

• Future Value of the 1st payment for an ordinary annuity is

F1 = PMT(1+r/n)m-1

• The future value of the next to last payment is

Fm-1 = PMT(1+r/n)

• The future value of the last payment is Fm = PMT.

• The total future value F = F1 + F2 + F3 + … + Fm-1 + Fm

 Continuing the calculation of a
long term annuity
• The future value is
• Eq1
• Now multiply the equation above by (1+r/n)

• Eq2
• Take Eq2 – Eq1

Note that m = nt. Simplifying gives the ordinary annuity future value
formula
 Formulas
• ORDINARY ANNUITY

• ANNUITY DUE – receives one more period of compounding

than the ordinary annuity so the formula is
 Example
• Find the future value of an ordinary annuity with a term of 25
years, payment period is monthly with payment size of $50.
Annual interest is 6%.

• F = $34,649.70
• Note: We only put in $15,000. This means that interest earned
was $19,649.70!
 Sinking Funds
• A sinking fund is when we know the future value of the annuity
and we wish to compute the monthly payment.
• For an ordinary unity this formula is

• For an annuity due the formula is

 Sinking Fund Example
• Suppose you decide to use a sinking fund to save $10,000 for a
car. If you plan to make 60 monthly payments (5 years) and you
receive 12% annual interest, what is the required payment for
an ordinary annuity?
 Real – Life Example
• In 18 years you would like to have $50,000 saved for your
child’s college education. At 6% annual interest, compounded
monthly, what monthly deposit must be made to accomplish this
goal?
• The question does not specify when the payments will be made
so we use both formulas for comparison.
• For the ordinary annuity

• For the annuity due

 10 The Mathematics of Money

Deferred Annuities:
Planned Savings for the Future
Fixed Annuity
A fixed annuity is a sequence of equal payments made or
received over regular (monthly, quarterly, annually) time
intervals.

Annuities (often disguised under different names) are so

common in today’s financial world that there is a good
chance you may be currently involved in one or more
annuities and not even realize it.

You may be making regular deposits to save for a

vacation, a wedding, or college, or you may be making
regular payments on a car loan or a home mortgage.
Deferred Annuity - Installment Loan
You could also be at the receiving end of an annuity,
getting regular payments from an inheritance, a college
trust fund set up on your behalf, or a lottery jackpot.

When payments are made so as to produce a lump-sum

payout at a later date (e.g., making regular payments into
a college trust fund), we call the annuity a deferred
annuity; when a lump sum is paid to generate a series of
regular payments later (e.g., a car loan), we call the
annuity an installment loan.
Deferred Annuity - Installment Loan
Simply stated, in a deferred annuity the pain (in
the form of payments) comes first and the reward
(a lump-sum payout) comes in the future, whereas
in an installment loan the reward (car, boat,
house) comes in the present and the pain
(payments again) is stretched out into the future.

In this section we will discuss deferred annuities.

In the next section we will take a look at
installment loans.
Example: Setting Up a College Trust Fund

Given the cost of college, parents often set up

college trust funds for their children by setting aside
a little money each month over the years.

A college trust fund is a form of forced savings

toward a specific goal, and it is generally agreed to
be a very good use of a parent’s money–it spreads
out the pain of college costs over time, generates
significant interest income, and has valuable tax
benefits.
Example: Setting Up a College Trust Fund

Let’s imagine a mother decides to set up a college

trust fund for her new-born child. Her plan is to have
$100 withdrawn from her paycheck each month for
the next 18 years and deposited in a savings
account that pays 6% annual interest compounded
monthly.

What is the future value of this trust fund in 18

years?
Example: Setting Up a College Trust Fund

In this example, money is being added to the account in

regular installments of $100 per month.

Each $100 monthly installment has a different “lifespan”: The

first $100 compounds for 216 months (12 times a year for 18
years), the second $100 compounds for only 215 months,
the third $100 compounds for only 214 months, and so on.
Example: Setting Up a College Trust Fund

Thus, the future value of each $100 installment is

different.

To compute the future value of the trust fund we will

have to compute the future value of each of the 216
installments separately and add.

Sounds like a tall order, but the geometric sum

formula will help us out.
Example: Setting Up a College Trust Fund

Critical to our calculations are that each installment is for a

fixed amount ($100) and that the periodic interest rate p is
always the same (6% ÷ 12 = 0.5% = 0.005).

Thus, when we use the general compounding formula, each

future value looks the same except for the compounding
exponent:

Future value of the first installment ($100 compounded for

216 months):
(1.005)216$100
Example: Setting Up a College Trust Fund

Future value of the second installment ($100

compounded for 215 months):
(1.005)215$100
Future value of the third installment ($100
compounded for 214 months):
(1.005)214$100
…
Future value of the last installment ($100
compounded for one month):
(1.005) $100 = $100.50
Example: Setting Up a College Trust Fund

The future value F of this trust fund at the end of 18

years is the sum of all the above future values.

If we write the sum in reverse chronological order

(starting with the last installment and ending with the
first), we get

(1.005) $100 + (1.005)2$100 + … +

(1.005)215$100 + (1.005)216$100
Example: Setting Up a College Trust Fund

A more convenient way to deal with the above sum

is to first observe that the last installment of
(1.005)$100 = $100.50 is a common factor of every
term in the sum; therefore,

$100.50[1 + (1.005) + (1.005)2 + … +

(1.005)214 + (1.005)215]
Example: Setting Up a College Trust Fund

You might now notice that the sum inside the

brackets is a geometric sum with common ratio c =
1.005 and a total of N = 216 terms. Applying the
geometric sum formula to this sum gives
 FIXED DEFERRED
ANNUITY FORMULA
The future value F of a fixed deferred annuity
consisting of T payments of $P having a
periodic interest of p (written in decimal form)
is

where L denotes the future value of the last

payment.
Example: Setting Up a College Trust Fund: Part 2

In the previous Example, we saw that an 18-year annuity of

$100 monthly payments at an APR of 6% compounded
monthly is $38,929.

For the same APR and the same number of years, how much
should the monthly payments be if our goal is an annuity with
a future value of $50,000?
Example: Setting Up a College Trust Fund: Part 2

If we use the fixed deferred annuity formula with F =

$50,000, we get

Solving for L gives

Example: Setting Up a College Trust Fund: Part 2

Recall now that L is the future value of the last payment, and
since the payments are made at the beginning of each
month,
L = (1.005)P. Thus,
Relationship Between F and P
The main point of Example is to illustrate that the
fixed deferred annuity formula establishes a
relationship between the future value F of the
annuity and the fixed payment P required to
achieve that future value.

If we know one, we can solve for the other

(assuming, of course, a specified number of
payments T and a specified periodic interest rate
p).
 Amortization Problem
Solution

• Problem: A bank loans a customer $50,000 at 4.5% interest per

year to purchase a house. The customer agrees to make
monthly payments for the next 15 years for a total of 180
payments. How much should the monthly payment be if the debt
is to be retired in 15 years?

• Solution: The bank has bought an annuity from the customer.

This annuity pays the bank a $PMT per month at 4.5% interest
compounded monthly for 180 months.
 Solution
(continued)

• We use the formula for present value of an annuity

and solve for PMT:
 Solution (continued)

Care must be taken to perform

the correct order of operations.
1. enter 0.045 divided by 12
2. 1 + step 1 result
3. Raise answer to -180 power.
4. 1 – step 3 result
5. Take reciprocal (1/x) of step 4
result. Multiply by 0.045 and
divide by 12.
5. Finally, multiply that result by
50,000 to obtain 382.50
 Solution
(continued)
• If the customer makes a monthly payment of $382.50
to the bank for 180 payments, then the total amount
paid to the bank is the product of $382.50 and 180 =
$68,850. Thus, the interest earned by the bank is the
difference between $68,850 and $50,000 (original
loan) = $18,850.