Annuity - What is it?

The term annuity or annuity rate is derived from the Latin word annus. Annus refers here to the entire year. Broadly speaking, the annuity therefore denotes the interest and principal repayments that accrue on a loan over the course of a financial year.

However, because payments and accounting in lending usually take place monthly rather than annually, the annuity for a loan changes every month. The annuity comprises, on the one hand, the applicable interest, and on the other hand the repayments already made.

At the start of a loan agreement, interest and repayment amounts are balanced against each other. With each repayment made, however, the outstanding balance decreases. As a result, the repayment portion in the annuity calculation increases, which in turn reduces the interest portion. In the annual total, interest and repayment together always form a constant annuity that continues over the entire term of the loan.

To make financial planning easier for the borrower, the repayment rate for an annuity loan is not adjusted every month, but only amended at the end — if necessary. Ideally, the calculation works out and the agreed portion of the outstanding balance is paid off after one year.

In the long run, the amount of the annuity can often be reduced if one opts not for monthly but for quarterly, semi-annual, or even annual payment intervals. However, not all lenders offer this option for every loan or credit product. You may therefore need to compare or search a little more carefully.

History of the annuity

The history of the annuity begins in ancient Rome, where the annuity principle was already referenced in antiquity for all important offices as well as credit, securities and monetary transactions. Originally, it referred to occupied offices. To ensure that no one abused a high office and remained aware of their duties, all offices were filled anew year by year. The annuity principle thus served to bring a certain order to these offices.

After it proved highly effective in politics following years of corruption, the annuity principle was eventually adapted and applied to the economy. In this context, the principle meant that borrowed money, land or goods, unless expressly agreed otherwise, had to be returned to the rightful owner at the latest after one year. At the same time, surpluses or other value transfers — which effectively functioned as ancient interest — were negotiated and paid in advance.

Trade also used the principle by "selling" goods in advance and agreeing to pay extra costs at a later date, for example at the end or beginning of a month. Only centuries later did the annuity principle reach Europe, and today it is associated exclusively with politics and the economy.

Annuity in lending

In economics and the related financial mathematics, the annuity appears as an overarching annual payment; a payment made up of the constituent parts of interest and principal repayment. A strict distinction is made here between constant and variable annuities. When one speaks of a constant annuity in general finance, this really refers to the annual repayment of outstanding debt.

The concepts of constant and variable annuity also appear in lending. While the popular and commonly used model of the repayment loan uses a variable annuity, the annuity loan uses a constant annuity rate.

The annuity, the annuity loan and the repayment loan

An annuity loan is a loan that features constant (unchanging) installments, providing a consistent repayment amount. Here, the rate amount is not adjusted as repayment progresses; instead the interest portion is reduced proportionally. The opposite is the repayment loan, which adjusts the variable installments monthly in line with the declining outstanding balance.

Which type of loan is right depends on individual circumstances. On average, one understandably starts with much higher repayment amounts with a repayment loan than with an annuity loan. However, the monthly financial burden of repayments for an annuity loan remains the same and is therefore more predictable for some borrowers.

Other borrowers take advantage of the fact that installments on the repayment loan shrink substantially toward the end and that the repayment period for a repayment or installment loan is often considerably shorter. This naturally reduces the total amount of interest paid over the period required to clear the outstanding balance.

Predictable loans thanks to annuity

Because an annuity loan is considered more predictable, most lenders prefer to offer consumer loans in this form. Exceptions are loans with smaller sums and shorter terms — especially those that are to be repaid not within a year, but within half a year or three quarters of a year. In Germany, the annuity loan is commonly used, among other things, in real estate and mortgage financing. Here the monthly interest rate is usually fixed for at least five years.

For smaller loan amounts, the contract term may be shorter, which also affects the interest. The higher the loan amount, the longer the term and usually the higher the annual interest to be paid. Depending on the overall duration of the loan agreement, the interest rate can also be fixed. This has the advantage that even if interest rates rise, borrowers can benefit from unchanged favorable rates.

However, a lower effective annual interest rate is not adjusted. This means that a loan taken out by the borrower can only be terminated after the agreed fixed period has expired. The borrower can decide whether to repay the loan in full (in one lump sum) or to negotiate a new annuity amount or interest rate.

Many borrowers use these options to look for a more advantageous loan offer or lender during the term of the loan. The latter then pays off the outstanding balance at the former financial institution, and the customer can repay their outstanding balance under the new and more favorable conditions of the new provider going forward.