We frequently receive questions from readers about Structured Settlement Annuity rates, asking about the effective rate shown on our available Structured Settlement Annuity offers . This is the discount rate at which you are buying the future payment stream. Many people assume this is a ‘loan’ with an interest rate paying annually, and that is not actually the case.
Another common misconception is that people incorrectly look only at the total payout and the total investment for calculating the interest rate. But because there are regular payments being made every month, the principal amount is declining with each payment. It’s exactly like an amortizing mortgage.
Lets look at a recent example, a payment stream of 200 monthly payments of $1000. This payment stream was set to close 04/01/12 and the first payment set for 05/01/12. The effective rate is 5%, and the purchase price was $136,605.97.
To use the mortgage analogy, consider a loan originated on April 1, 2012 with a principal amount of $136,605.97 with 200 monthly payments of $1000 due beginning May 1, 2012. This loan has a total payment to the lender of $200,000 over the term of the loan. The interest rate on this mortgage is 5%, and each payment would be exactly $1000 and the loan would be completely paid off in 16 years and eight months.
The lender, in this case, gave you $136,605 in exchange for your promise to pay back $200,000- it’s a 5% discount rate for the lender on those future payments.
In the case of a structured settlement cash flow, you are paying $136,605 for the right to receive $200,000 in total payments, paid over 200 months. You are buying those future payments at a discount.
Another way to look at it is to assume you put $136,605.97 into a savings account earning 5% annual compound interest on 4/1/12. If $1000 was withdrawn on the 1’st of each month starting 5/1/12, after 200 months you would have withdrawn $200,000 and your account would be empty.
Of course, if savings accounts paid rates this high, there would be no need to consider Structured Settlement Annuities or Secondary Market Annuities – but savings rates are much lower, which further illustrates why these are such compelling opportunities.
To use more mathematical finance terms, definite payment stream like this structured settlement annuity is a series of future payments. The effective rate we quote is the discount rate at which the Net Present Value (NPV) of all the future payments is equal to $0.
To do this in MS Excel, input each payment amount starting with a negative for your investment, and a positive amount for each income payment. Input the exact date of each payment and use the XIRR function, and you will arrive at the effective rate. We’re happy to supply you with a MS excel table of any settlement you are considering to illustrate, but this is something fewer investors are familiar with, which is why we like the mortgage analogy.
Finally, a single lump sum investment is often an easier way to understand- $100,000 invested on 1/1/12 and paying $200,000 on 12/31/21 is an effective discount rate of 7.18%. This is an annual, compounding rate. With no monthly payments to contend with, it’s easy to verify with any compount interest calculator.
We hope this clarifies some misunderstandings about structured settlement rates.