Present Value Calculator seems to have come to the rescue of those people who cannot successfully apply the complex formula that was developed for the calculation of present value of annuity. But whether you are using the present value calculator or the formula to work out what the present value of an annuity is, the variables still remain the same. Without your understanding of these variables, you may not actually know how to apply them correctly. The danger is that, if you don’t get the variables right, you will always get the wrong result. This can result to a wrong de calculation of present value is to stress the importance of time value of money. $1,000 received today is worth more than the same received in the future date.
Let’s look at the formula for the calculation of an ordinary annuity first. Please, note that if you are using present value calculator, the formula is already built into the calculator. All you need to do is to enter your figures. That is why you need to understand the variables that are used for the calculation of the present value.
PV = P [(1 – (1 / (1 + r)n)) / r]
PV = Present value
P = Payment amount
I = Interest rate per period
N = Number of periods
Let’s try to explain the variables further so that you can have a better understanding of the formula.
Payment amount: This is the series of evenly spaced equal amount made over a period of time. For example, if you pay $1,000 every month towards an annuity, then that $1,000 becomes your payment amount.
Interest rate: Everybody is familiar with interest rate. But when it comes to the calculation of present value, this can be like a trick. The reason is that, the interest rate you are going to use depends largely how the interest will be compounded. For example, if you pay $12,000 as a bulk figure annually, the interest you will receive on this amount will be different from the person who pays $1,000 every month to make up the $12,000. Supposing the annual interest rate is 10%. If the interest is going to be compounded on every month, then the interest rate has to be pro-rate on monthly basis. The monthly interest rate will then be calculated 10/12, which is 0.83% per month. The beauty of using present value calculator is that all the calculation will be done automatically as long you select the right criteria.
Read Also: See How High Interest Rate Is Killing You
Number of periods: This is the number of years you will need to pay towards the annuity.
Payment interval: I have talked about this when explaining how interest rate applies to the calculation of present value of annuity. The payment interval may be monthly, quarterly, semi-annually or annually. Your payment interval will have direct impact on the interest rate to apply and the number of periods covered. You shouldn’t allow this to confuse you. The present value calculator will take care of this for you.
Assumptions for the calculation of present value
Both present value calculator and present value formula use certain underlying assumptions. These assumptions can also be considered as the limitations of the two approaches. These assumptions are as follows:
- Interest rate is fixed: It is expected that the interest rate will remain fixed throughout the annuity period. In actual sense, this may not be realistic. Interest rates can fluctuate.
- Payment amount does not change: Present value calculator and the formula assume that you will be making the same amount of payment or a regular basis. The truth is that, a person can decide to increase his contributions as the year progresses.
- The first payment is one period away: If you are making the payment annually, present value calculator assumes that the next payment will be due exactly twelve month from the date you make the first payment. That is, if you start making payment by July 1 of this year, then the next payment will be due by July 1 next year.
- Payment interval remains the same: Neither of the Present Value Calculator nor the formula makes provision for the change of payment interval. If you are making payments on a quarterly basis, you can’t change to making the payment semi-annually.
- Growing rate: Certain present value calculators assume that there is possibility for anyone to want to increase his payment amount. If this happens, it is assumed that the growing rate is going to be fixed. For example, one may decide to be increasing his payment amount by 10% every year
Advantages of using present value calculator
Easy to use: It takes some computational or mathematical skills to be able to use the formula to calculate the present value of annuity. With the present value calculator, if you can read and you are able to define your parameters, you will be able to do this with ease.
Speed: Within few minutes, you can calculate present value of annuity.
Flexibility: You can keep changing your parameters until you arrive at the figures that will help you achieve you financial or investment goals.