What it means
Many financial deals offer you a choice. You can take all the money now, or you can accept smaller amounts over a period.
The lump sum gives you control and immediate access, while instalments give you a steady stream and often a larger total. The main tool for comparing the two is present value.
A dollar today is worth more than a dollar next year, because today's dollar can be invested or used immediately. To compare fairly, you discount the future instalments back to today at a sensible rate and see whether the total is higher or lower than the lump sum.
Tax and risk can change the answer. A large lump sum may push you into a higher tax bracket in a single year, whereas instalments spread the tax.
On the other hand, instalments depend on the payer remaining solvent and willing to pay, which a lump sum removes. Behaviour matters as well.
People who receive a large sum sometimes spend it faster than planned, while a regular payment forces discipline. This is one reason pension schemes often default to income for life, and why advisers suggest a plan for how the money will be used.
Businesses face the same choice in reverse. A company buying a licence or settling a claim might pay one amount up front for a discount, or spread payments to protect its cash.
The sensible choice depends on its cost of borrowing and cash position. In accounting terms, a lump sum is usually recorded in full when it is received or paid, although the accounting standards may require the related income or cost to be spread across the periods it covers.
For example, an upfront payment for a three-year service contract would normally be recognised gradually, even though the cash arrived at once.
In practice
Real-world examples.
Example
A retiring employee is offered either a monthly pension or a $250,000 lump sum. She compares what the lump sum could provide if invested with the guaranteed income and decides to take the pension because she values certainty.
Example
A software start-up sells a customer a three-year licence. The customer pays $90,000 up front instead of $35,000 a year, and the start-up gives a discount because receiving the cash earlier funds hiring.
Example
An accident claimant accepts a lump sum settlement of $180,000 rather than ongoing payments. His lawyer advises him to place most of it in a diversified investment account and to keep a year's expenses in cash.
Formula
Calculation
Present value of instalments = Payment 1 / (1 + r) + Payment 2 / (1 + r)^2 + ...
A claimant is offered a settlement of $95,000 now, or $55,000 in one year and $60,500 in two years. Assume the claimant can earn 10% a year elsewhere. The present value of the first instalment is 55,000 / 1.10 = $50,000. The second is 60,500 / 1.21 = $50,000. The total present value is $100,000, which is higher than the $95,000 lump sum, so at a 10% discount rate the instalments are worth more, provided the payer is reliable.Case study
Seen in the real world.
Oakridge Dental Group is an illustrative, fictional practice that sold its equipment-leasing arm. The buyer offered $2,000,000 as a lump sum, or $450,000 a year for five years. The finance director discounted the instalments at the group's borrowing cost of 8% and found that their present value was about $1,800,000.
She recommended the lump sum, because it was worth more in today's money and removed the risk that the buyer might default. In this fictional story the group used the cash to repay a loan costing 8%, which gave a certain return and strengthened the balance sheet.
Her board also asked what would happen if interest rates rose. At a higher rate the instalments would be worth less today, which strengthened the case for the lump sum, and the fictional board approved the decision unanimously.
Watch out
Common mistakes.
- Comparing a lump sum with the simple total of instalments, when the instalments should be discounted to present value first.
- Ignoring tax, which can make a large single payment less valuable after the bill is paid.
- Taking a lump sum without a plan, which makes it easy to spend or lose it too quickly.
Questions
People also ask.
When is a lump sum usually better?
It tends to be better when you have a good use for the money, such as paying off expensive debt, or when you doubt that the payer will keep paying.
When are instalments usually better?
They tend to be better when you value steady income, want to spread the tax and trust the payer to continue.
What discount rate should I use?
Use the return you could realistically earn on a similar-risk alternative, such as your borrowing rate or your expected investment return.
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