Annuities

An annuity is the payment or receipt of equal cash amounts per period for a specified amount of time. Some common applications are insurance and retirement plan premiums and payouts; loan payments; and savings plans for future events such as starting a business, going to college, or purchasing expensive items (e.g., real estate or business equipment). Simple annuities are annuities in which the number of compounding periods per year coincides with the number of annuity payments per year. Complex annuities are those in which the annuity payments and compounding periods do not coincide. As with compound interest, annuities can be calculated manually, by tables, and by formulas. Manual computation is useful for illustrative purposes; however, it is too tedious because it requires a calculation for each period. A sinking fund situation occurs when the future value of an annuity is known and the payment required each period to amount to that future value is the unknown. Sinking funds are accounts used to set aside equal amounts of money at the end of each period at compound interest for the purpose of saving for a future obligation. Businesses use sinking funds to accumulate money for such things as new equipment, facility expansion, and other expensive items needed in the future. Another common use is to retire financial obligations such as bond issues that come due at a future date. Individuals can use sinking funds to save for a college education, a car, the down payment on a house, or a vacation. Amortization is a financial arrangement whereby a lump-sum obligation is incurred at compound interest now (present value) and is paid off or liquidated by a series of equal periodic payments for a specified amount of time. With amortization, the amount of the loan or obligation is given and the equal payments that will amortize, or pay off, the obligation must be calculated. Some business uses of amortization include paying off loans and liquidating insurance or retirement funds.