What is Amortization?
Amortization is the process of spreading the payments of a loan out over time; it can also refer to how you account for capital expenses related to intangible assets over time.
🤔 Understanding amortization
Amortization is the process of structuring loan payments over the life of the loan. It organizes the payments, determining how much of each payment goes to principal and how much to interest. This is called an amortization schedule. Amortization can also refer to spreading the cost of an intangible asset out over time for tax and accounting purposes.
Say you buy a new car using a loan. The payment you are quoted includes a sliding scale of interest vs. principal amounts within that payment, using amortization and an amortization schedule. If you take a $25,000 loan at 4% interest for 60 months, say, your payment quote might be around $460/month. The amortization schedule might show you that in the first month, $83 of that goes to interest, and $377 goes to principal. In the 15th month, $65 goes to interest, and $395 goes to principal. By the last payment, the full $460 goes to paying off the principal.
Amortization is like eating a pie over the course of a week...
Ideally, you don’t want to eat the pie all at once — like you may not want to pay for that new car all at once. But if you cut it up into seven pieces and eat one a day, it will all add up in the end.
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What is the purpose of amortization?
Part of the reason for amortization is to protect a borrower. Amortization spreads out the interest paid rather than requiring a borrower to pay all the interest for the planned life of the loan upfront before any principal is paid. For a borrower, this means they begin building equity in a home or other large asset with their first payment.
For smaller loans, like car loans, it makes the loan easier to pay off early by reducing principal from the beginning. This structure is especially beneficial to borrowers if they make extra payments directly to the principal early in the life of the loan. By making early principal payments, the borrower can reduce future interest charges by effectively shortening the timeframe over which they will be paying off their loan.
How does loan amortization work?
Amortization is just a way of organizing the amount borrowed and the interest due so that payments can be predictable for the length of a loan. The lender uses a formula (or a table based on a formula) to set the payment amount based on loan total and interest rate. Each payment made is split up and applied partially to interest due and partially to principal. At the beginning of the loan, more of each payment goes to interest and less to the principal. Throughout the life of the loan, this slowly reverses, so at the end of the loan, the majority of the payment goes to principal and very little to interest.
There are some cases where it is possible to run into negative amortization. In these cases, a lender may offer you the chance (either as a promotional option for an initially lower payment or in response to a short term financial hardship) to make a significantly smaller payment than usual that covers no principal and only part of the interest owed. In this case, the interest not paid is added to the total owed on the loan. Depending on the loan, you may then be charged interest on that new amount added to the loan total. These new charges, along with no reduction of principal, means that you could owe interest on interest. It also means you would now owe more than you originally borrowed, all while making payments. Then, when the promotional lower payments end, your regular payment amount must be raised to cover the new total of the loan.
For example, if you borrow $250,000 that would typically have a payment of $800 a month, the lender may offer a promotional choice of paying only part of the interest due the first six months of the loan. This might reduce your payment to $250 temporarily. However, that $250 only covers part of the interest due each month and none of the principal. Each month the remaining unpaid interest is added to the total you owe. At the end of the six months, you owe more than the initial $250,000 you borrowed because of the added unpaid interest. Then, your payments may be raised to reflect the new amount owed. In effect, you would have made payments for six months and lost money.
What is the difference between amortization and depreciation?
While you may be most familiar with amortization as a way of scheduling loan payments, it can also be used in accounting as part of spreading the cost of assets over time, similar to depreciation. When used this way, the main difference in amortization and depreciation is that depreciation is used for objects (like computers or cars), and amortization is used for intangible things (like patents or copyrights).
Where depreciation takes the cost of a physical item and splits it across a specific amount of time (like 10 years), amortization takes the price of an intangible asset — for example, a license to manufacture shirts featuring characters created by another company — and spreads that cost over time. So, if a company paid $100,000 for a license that would last 10 years, the amortized cost would be $10,000 per year ($100,000÷10).
What kinds of loans are amortized, and what kinds are not amortized?
Not all loans are amortized. Loans with a set payment schedule, calculated to pay off the loan and interest in a set amount of time, are amortized. Examples are car loans, mortgages, and personal loans.
Some loans do not have a payment structure that ends with the loan being paid off. Instead, it is up to the borrower to pay more than the minimum payment required to start paying down the total owed. Credit cards are a common example of this type of loan.
Most non-amortized loans, like balloon payment mortgages and interest-only loans, still have a due date for the amount owed. At that time, the remaining amount owed on the loan becomes due as a lump sum –- Unless there is a refinancing option offered. If the borrower cannot pay the balance owed or refinance that amount owed, they can be in default.
What is an amortization schedule?
An amortization schedule is a list of amortized payments over the life of a loan. It is often expressed as a table, which spells out the payment amount. The table also shows how much of each payment made goes to interest and how much of each payment made goes to the principal. Sometimes an amortization schedule is called an amortization table because it generally uses a table type format.
Amortization schedules typically include the date of payment due, the payment amount, the interest part of the payment, the principal part of the payment, the total interest paid to date, and the remaining balance to date. However, not all schedules include the total interest paid and the remaining balance to date data.
|Payment Date||Payment Amt.||Principal||Interest||Interest Total||Principal Remaining|
The example schedule above is an excerpt from an amortization schedule for a $25,000 car loan at 4.5% for five years.
How do you amortize a loan?
Because of the complexities of the math involved, nearly all amortization of loans is done electronically. Most amortization calculators have a function to print out an amortization schedule. While there are many loan amortization calculators available online, you may prefer to use your own Excel or Google Sheets amortization calculator. Microsoft offers a free loan amortization download for Excel so that no coding on your part is required at all. Google also provides a free loan amortization schedule download for Sheets that requires no coding from you. For any of these calculators, you will need to know the interest rate (as a decimal), the years of the loan, the number of payments per year, and the amount borrowed.
We have also created a sample amortization table for you in Excel that can be downloaded.
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