We have all seen the ads on TV for offers to buy your structured settlement, lottery winnings, or mortgage note. The question is how much will you get? Well the answer to that is not straight forward, but here are a couple of factors to consider when determining the value of your annuity.
The main thing to consider is how long the receipt of payments will last. The more time a payment stream covers, the less it is worth in today's dollars. For example, if you are to receive $500,000 over 20 years, that is worth more than receiving that same $500,000 over 30 years. Why, because of the time value of money.
The time value of money essentially says that a dollar today is worth more than a dollar tomorrow, so it stands to reason that $500,000 collected over 20 years is worth more than $500,000 collected over 30 years. You can think of this from the buyers standpoint also.
If you have $50,000 invested at 12%, your money will tend to double every 6 years. After 12 years of compounding, you will have $200,000. But what if you only get 6%? Since at this rate, your money doubles every 12 years, it will take 24 years to compound to $200,000. Which is more valuable? Of course getting the $200,000 in only 12 years rather than 24 years is more valuable since you don't have to wait as long.
The second thing to consider is the current interest rate for long term bonds - that is a bond having roughly the same maturity or life as your annuity. You can expect to have your payment stream discounted to a present value lump sum using a rate close to this. This is because that rate is the investors next best alternative for a similar investment. What is meant by discounting your payment stream?
When a stream of payments is discounted over a period of time, it is essentially converted into today's dollars. In other words, how much money would you need to invest today (at the discount rate) to have the same amount of money as all the payments added together at the end of the annuity? This is the amount the investor is willing to pay for your income stream in order to earn the rate of return he wants.
The discount rate the investor uses can be higher or lower than the market rate - it just depends on what rate of return is required by the investor and how risky the annuity is.
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