An ordinary annuity is a series of payments having the following three characteristics:
- All payments are in the same amount (such as a series of payments of $1,000).
- All payments are made at the same intervals of time (such as once a month or quarter, over a period of a year).
- All payments are made at the end of each period (such as payments being made only the last day of the month).
Usually, payments made under the ordinary annuity concept are made at the end of each month, quarter, or year, though other payment intervals are possible (such as weekly or even daily). Examples of ordinary annuity payments are:
- Semi-annual interest payments on bonds
- Quarterly or annual dividend payments
Because payments are made sooner under an annuity due (where payments are made at the beginning of each period) than under an ordinary annuity, an annuity due has a higher present value than an ordinary annuity.
When interest rates rise, the value of an ordinary annuity is reduced. When interest rates decline, the value of an ordinary annuity is increased. The reason for these variations is that the present value of a stream of future cash payments is dependent on the interest rate used in the present value formula. As the time value of money changes, so does the annuity valuation.
Here are several examples of ordinary annuities:
- A bond has an $80 coupon payment that is paid at the end of every six-month period until the bond matures. Since all payments are in the same amount ($80), they are made at regular intervals (six months), and the payments are made at the end of each period, the coupon payments are an ordinary annuity.
- Mrs. Jones has retired, and her former employer's pension plan is obligated to send her a pension payment of $400 at the end of each month for the rest of her life. Since all payments are in the same amount ($400), they are made at regular intervals (monthly), and the payments are made at the end of each period, the pension payments are an ordinary annuity.