Definition of Annuity: Types, Formulas, and Examples of Calculating It!

Definition of Annuity – For some people, maybe annuity is not a general term. However, for people who have professions in finance, annuities are familiar. For those of you who may have applied for a loan at a bank, you must have heard briefly of the meaning of an annuity itself.

So, based on banking theory, an annuity is a payment or receipt that is made periodically and routinely for a certain period. Annuity can also be described as a payment process in the same amount and is carried out at a certain time. In short, annuity can be interpreted as installments.

Even though the name is installments, this annuity is not only related to credit or debt payments. When you make payments for insurance premiums, this annuity will also be used. In the banking world, this annuity will be used to calculate the amount of interest or investment.

The goal itself is to make it easy for customers to make payments and also receive the amount of profit from the investment they have. Check out the full review of the meaning of annuity here!

Definition of Annuity

In the world of financial economics, the notion of an annuity is all a series of fixed receipts or payments that are made periodically and continuously and are still continuous within a certain period or period of time. Based on this explanation, we can conclude that an annuity is an installment payment or receipt of a fixed value if paid or received within a certain period of time.

The definition of an annuity is actually not limited to payments or receipts that are periodic and related to loans or credit as well. However, it can also be used as an investment to prepare for financial independence in the future. More broadly, the notion of an annuity is also often used in an insurance product. In the world of insurance, it can be interpreted as a pension benefit that is paid regularly every month.

Understanding Annuity is a contract between workers and an insurance company, in which each worker will make various series of payments. In return, they will get regular disbursements after the allotted time has arrived.

Meanwhile, in the investment world, annuities are used for future financial planning in order to provide a stable stream of income during retirement. Funds that will be paid by workers will be given periodically while they are still working. For the number itself will certainly increase every year until retirement has arrived.

If we return to the financial context, this annuity will be used to calculate loan interest and long-term investment interest. The purpose of using this annuity is to make it easier every month during the loan period. As with investments, the goal is to make it easier for investors to get returns every month during the investment period.

Types of Annuities

Credit installments or loans are generally determined at the same time every month during the credit period. So that it can be paid at the beginning of the period or at the end of the period. The same is true for receiving investment returns. Taking into account these conditions, judging from the term of payment, annuities can be divided into four types, including:

1. Ordinary Annuity

An ordinary annuity is a type of annuity where payments or receipts are made periodically for a certain period at the end of the period. For example, mortgage payments where mortgage payments and receipts are paid or received at the end of the period.

2. Due Annuity or Due Annuity

Annuity due or due annuity is a type of annuity where payments or receipts will be made periodically for a certain period of time that occurs at the beginning of the period. The most common example of an annuity due is an insurance product. When using an insurance product, we must pay a premium before we can claim from the insurance product that we use. Apart from insurance, products with annuity maturities include rental agreements, rentals, and so on.

3. Deferred Annuity or Deferred Annuity

A deferred annuity is a type of annuity or periodic receipt for a certain period of time that occurs or is made after a certain period of time has passed. Therefore, payment or receipt may be delayed.

4. Immediate Annuity or Immediate Annuity

A direct annuity is an annuity in which receipts or payments are made periodically over a certain period of time or are made directly without delay within a certain period of time. An example of an immediate annuity is when you buy a car on credit. Because, payments and receipts are fixed, so you can do it without any delay period.

Advantages and Disadvantages of Annuities

Keep in mind that calculating interest on an annuity has its own advantages and disadvantages. As we discussed earlier, the purpose of an annuity is to make it easier for clients to pay or receive a return on their investment. In the credit process, the existence of this annuity allows the borrower to pay the same amount in installments each period. Unlike the calculation of the effective interest obtained from dividing the ceiling by the tenor, in an annuity the principal installment value will be calculated based on the total installments, then reduced by the annuity interest.

Although quantitatively the value is the same as the actual interest rate, the composition of this annuity interest is different. With an annuity system, credit interest payments will be greater at the beginning and then decrease as the credit period progresses. And vice versa, the principal payment value will be even higher. The structure of principal payments as well as interest will continue to change over the term of the credit, but the amount itself will remain the same in nominal terms.

The payment system with this annuity is considered fair and reasonable, because the interest rate is calculated based on the amount of principal payments that are still outstanding. However, some argue that this annuity can be detrimental to the borrower. Especially if the borrower wants to pay off his debt. This is because, at the beginning, the composition of the installments tended to be paid more for interest, the principal debt did not decrease much. This is considered heavy because the main debt burden is still large.

Annuity Rating

To be able to determine the value of this annuity, it is necessary to calculate the value of payments to be made in the future. The valuation will require consideration of the time value of money, future value, and also the interest rate. The present value of an annuity itself is the value of a stream of payments discounted by the interest rate to account for those payments, which must be made at a different time in the future.

As mentioned above, this annuity calculation is often used to calculate the value of loan interest rates. So that the value of the monthly payment, which is the principal of the loan, is then added to the interest rate. The borrower must pay during the loan period. In addition, this annuity calculation can also be used to calculate investment interest as well as deposits or other long-term investments. In this field, annuity calculations are carried out so that the profit earned can be invested in investment funds or deposits in the form of time deposits or other types of long-term investments.

This interest calculation is very different from fixed interest and is equally effective, although it can result in the same number of payments or payment amounts. However, in principle, this interest calculation is the result of a modification or change in the value of the calculation of the effective interest rate. The goal itself is to make it easier for borrowers to pay the same down payment each period. When calculating effective interest, pay back the principal by dividing the credit limit by the term or term of the loan.

This is different from the annuity calculation, where the principal installment value is calculated from a predetermined number of installments. Then, minus the annuity results. It sounds quite complicated, right, so it takes several applications that are used to calculate annuity interest.

Although the amount of the annuity payment has the same value as the actual interest rate, the structure is quite different. From the start, the number of installments generated and also the interest will be greater than the principal. Therefore, with each payment period, the interest rate will tend to decrease during the credit period. On the other hand, the principal payment will certainly increase over the term of the loan. The structure of interest payments and also the principal will of course be higher during the credit period and this interest rate system will continue to change periodically until the end of the credit period. The calculation of this annuity interest will be fairer because the interest will be charged on the remaining principal or unpaid loans. However,

Because, after installments, there are several maturities and also the borrower wants to pay off the loan immediately. This causes the main burden of the loan to be paid to have a large value. In addition, because installment payments are given at the beginning, most of them are in the form of interest. So that the principal loan is only slightly reduced.

Annuity Interest Formula

The formula for calculating the annuity interest rate is as follows:

Annuity = SP X ix (30/360)

SP = Principal balance of the previous month
i = Interest rate per year
30 = Number of days in a month
360 = Number of days in a year

However, the annuity calculation formula was further developed to obtain the appropriate value based on the annuity formula to become: