What is Present Value of An Annuity?
Present value of an annuity is a time value of money formula used for measuring the current value of a future series of equal cash flows.
The two most popular uses are for calculating loan payments and for calculating retirement funding needs. Both use the same formula, it's just that they work in opposite directions.
For example, if you would like have enough money in a retirement account so that you can withdraw $2,000 per month for twenty years, and you believe you can earn 6% on your money, present value calculations will tell you that you will need to have $279,161.54 in your retirement account on the day you retire.
Conversely, if you wanted to take out a $279,161.54 mortgage for a home on a 6%, 20-year monthly repayment term, present value calculations with tell you that your monthly payments will be $2,000.00.
Being On the Right Side of Compounding Interest Equation
Continuing with the above example, if you multiply the number of mortgage payments by the number of payment periods, you will find that the total of all monthly payments for the 20-year mortgage add up to $480,000 ($2,000 x 12 months x 20 years). That's $200,838.46 more than the $279,161.54 you borrowed!
So why are you paying back so much more than you borrowed? The difference is the result of compounding interest. And in the case of a mortgage loan, interest is being compounded on the entire amount you owe each time you make a payment. This means you are being charged interest on the same borrowed dollars many times over. In fact, by the time you pay back the last dollar you owe to the mortgage company, you will have been charged the full annual interest rate on that dollar 20 times. Ouch!
On the other hand, if you could manage to accumulate $279,161.54 in an account earning 6% compounding interest, you could withdraw $2,000 from the account every month for 20-years -- which is $200,838.46 more than you started out with!
Again, that is the due to compounding interest. But in this case YOU are the lender who is charging the borrower interest over and over again on many of the dollars you loaned them. And the most important thing to be aware of in this scenario, is that the difference between receiving $200,838.46 more than you lend and paying out $200,838.46 more than you borrow is actually $401,676.92 (+$200,838.46 - -$200,838.46 = $401,676.92)! This is why it's so important to be on "the right side of the compounding interest equation."