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Understanding Annuities


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Understanding Annuities


An annuity is a method of accumulating a lump sum of money through a series of regular and equal payments and the reverse, being the liquidation of a lump sum through a series of regular and equal payments.

To annuitize a sum of money means to convert the sum to a series of monthly incomes such as the creation of a monthly retirement income flow.

To understand the math involved in the calculation, one should understand the basics of simple and compound interest. The process involves the interaction of value and time and the interest rate.

Example: ( Ordinary Annuity Certain)

What is the value of a monthly contribution of $100 over 5 years at an interest rate of 5%? compounding monthly.

Using a simple interest formula, one could go through the process of calculating the value of each contribution. Shown below, however, this would be a lot of work and can be calculated using a formula because the contribution amount and the intervals are consistent. See step 2 next for the actual annuity formula.

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