Definition of amortization


What is amortization?

Amortization is an accounting technique used to periodically reduce the book value of a loan or an intangible asset over a specified period of time. In relation to a loan, amortization focuses on spreading the loan payments over time. When applied to an asset, amortization is similar to depreciation.

Key takeaways

  • Amortization generally refers to the process of amortizing the value of a loan or an intangible asset.
  • Lenders, like financial institutions, use repayment schedules to present a loan repayment schedule based on a specific due date.
  • Amortized intangibles (accounted for as expenses) over time help link the cost of the asset to the income generated by the asset in accordance with the principle of consistency of generally accepted accounting principles (GAAP).

Understanding amortization

The term “amortization” refers to two situations. First, amortization is used in the debt settlement process through regular payments of principal and interest over time. An amortization schedule is used to reduce the current balance of a loan, such as a mortgage or car loan, through installment payments.

Second, amortization can also refer to the distribution of capital expenditures related to intangible assets over a specific period, usually over the useful life of the asset, for accounting and tax purposes.

Loan repayment

Amortization can refer to the process of paying off debt over time in regular installments of interest and enough principal to pay off the loan in full before its due date. A higher percentage of the fixed monthly payment goes to interest at the beginning of the loan, but with each subsequent payment, a higher percentage goes to the principal of the loan.

Amortization can be calculated using most modern financial calculators, spreadsheet software packages (such as Microsoft Excel), or online amortization calculators. Repayment schedules begin with the outstanding balance of the loan. To arrive at the amount of the monthly payments, the interest payment is calculated by multiplying the interest rate by the outstanding balance of the loan and dividing by 12. The amount of principal owed in a given month is the total monthly payment (a fixed amount) minus the interest payment for that month.

For the following month, the outstanding loan balance is calculated as the previous month’s outstanding balance minus the most recent principal payment. The interest payment is calculated once more from the new outstanding balance, and the pattern continues until all principal payments have been made and the loan balance is zero at the end of the loan term.

Amortization calculation

The formula to calculate the monthly principal owed on an amortized loan is as follows:

Principal Payment = Total Monthly Payment – (Outstanding Loan Balance X (Interest Rate/12 Months))

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Generally, the total monthly payment is specified when you get a loan. However, if you are trying to calculate or compare monthly payments based on a certain set of factors, such as loan amount and interest rate, you may also need to calculate monthly payment. If you need to calculate the total monthly payment for any reason, the formula is as follows:

Total Monthly Payment = Loan Amount [ i (1+i) ÷ n / ((1+i) ÷ n) - 1) ]

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Where:

  • i = monthly interest rate – You will need to divide your annual interest rate by 12. For example, if your annual interest rate is 3%, your monthly interest rate will be .0025% (.03 annual interest rate / 12 months).
  • n = number of payments during the life of the loan – Multiply the number of years in your loan term by 12. For example, a four-year car loan would have 48 payments (four years X 12 months).

Amortization of intangible assets

Amortization can also refer to the amortization of intangibles. In this case, amortization is the process of expending the cost of an intangible asset over the projected life of the asset. Measures the consumption of the value of an intangible asset, such as goodwill, a patent, a trademark, or a copyright.

Amortization is calculated in a similar way to depreciation, which is used for tangible assets, such as equipment, buildings, vehicles, and other assets subject to physical wear and tear, and depletion, which is used for natural resources. When companies amortize expenses over time, they help link the cost of using an asset to the income it generates in the same accounting period, in accordance with generally accepted accounting principles (GAAP). For example, a company benefits from the use of a long-term asset for several years. Therefore, it amortizes the expense incrementally over the useful life of that asset.

The amortization of intangibles is also useful in tax planning. The Internal Revenue Service (IRS) allows taxpayers to take a deduction for certain expenses: geological and geophysical expenses incurred in oil and natural gas exploration, air pollution control facilities, bond premiums, research and development (R&D). D), acquisition of leases, afforestation and reforestation. and intangibles, such as goodwill, patents, copyrights, and trademarks.

The IRS has schedules that dictate the total number of years in which to spend tangible and intangible assets for tax purposes.

Why is amortization important?

Amortization is important because it helps companies and investors understand and forecast their costs over time. In the context of loan repayment, amortization schedules provide clarity on how much of a loan payment consists of interest versus principal. This can be useful for purposes such as deducting interest payments for tax purposes.

Amortizing intangible assets is important because it can reduce a company’s taxable income, and therefore its tax liability, while giving investors a better understanding of the company’s true earnings.

Amortization example

Let’s look at a $ 30,000 four-year auto loan at 3% interest. The monthly payment will be $ 664.03. It comes down to this:

$30,000 ((.0025 (1.0025 ÷ 48) / (1.0025 ÷ 48) - 1)).

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In the first month, $ 75.00 of the monthly payment of $ 664.03 goes to interest.

$30,000 outstanding loan balance X 3% interest rate / 12 months 

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The remaining $ 589.03 goes to equity.

$664.03 total monthly payment – $75.00 interest payment 

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Each month, the total payment remains the same, while the part that goes to principal increases and the part that goes to interest decreases. In the last month, only $ 1.66 in interest is paid, because the outstanding balance of the loan at that time is very minimal compared to the beginning balance of the loan.

Loan amortization schedule
Period Total payment due Interest owed calculated Principal due Main Balance
$ 30,000.00
1 $ 664.03 $ 75.00 $ 589.03 $ 29,410.97
two $ 664.03 $ 73.53 $ 590.50 $ 28,820.47
3 $ 664.03 $ 72.05 $ 591.98 $ 28,228.49
4 $ 664.03 $ 70.57 $ 593.46 $ 27,635.03
5 $ 664.03 $ 69.09 $ 594.94 $ 27,040.09
6 $ 664.03 $ 67.60 $ 596.43 $ 26,443.66
7 $ 664.03 $ 66.11 $ 597.92 25,845.74
8 $ 664.03 $ 64.61 $ 599.42 $ 25,246.32
9 $ 664.03 $ 63.12 $ 600.91 $ 24,645.41
10 $ 664.03 $ 61.61 $ 602.42 $ 24,042.99
eleven $ 664.03 $ 60.11 $ 603.92 $ 23,439.07
12 $ 664.03 $ 58.60 $ 605.43 $ 22,833.64
13 $ 664.03 $ 57.08 $ 606.95 $ 22,226.69
14 $ 664.03 $ 55.57 $ 608.46 $ 21,618.23
fifteen $ 664.03 $ 54.05 $ 609.98 $ 21,008.24
sixteen $ 664.03 $ 52.52 $ 611.51 $ 20,396.73
17 $ 664.03 $ 50.99 $ 613.04 $ 19,783.69
18 $ 664.03 $ 49.46 $ 614.57 $ 19,169.12
19 $ 664.03 $ 47.92 $ 616.11 $ 18,553.02
twenty $ 664.03 $ 46.38 $ 617.65 $ 17,935.37
twenty-one $ 664.03 $ 44.84 $ 619.19 $ 17,316.18
22 $ 664.03 $ 43.29 $ 620.74 $ 16,695.44
2. 3 $ 664.03 $ 41.74 $ 622.29 16,073.15
24 $ 664.03 $ 40.18 $ 623.85 $ 15,449.30
25 $ 664.03 $ 38.62 $ 625.41 $ 14,823.89
26 $ 664.03 $ 37.06 $ 626.97 $ 14,196.92
27 $ 664.03 $ 35.49 $ 628.54 $ 13,568.38
28 $ 664.03 $ 33.92 $ 630.11 $ 12,938.28
29 $ 664.03 $ 32.35 $ 631.68 $ 12,306.59
30 $ 664.03 $ 30.77 $ 633.26 $ 11,673.33
31 $ 664.03 $ 29.18 $ 634.85 $ 11,038.48
32 $ 664.03 $ 27.60 $ 636.43 $ 10,402.05
33 $ 664.03 $ 26.01 $ 638.02 $ 9,764.02
3. 4 $ 664.03 $ 24.41 $ 639.62 $ 9,124.40
35 $ 664.03 $ 22.81 $ 641.22 $ 8,483.18
36 $ 664.03 $ 21.21 $ 642.82 $ 7,840.36
37 $ 664.03 $ 19.60 $ 644.43 $ 7,195.93
38 $ 664.03 $ 17.99 $ 646.04 $ 6,549.89
39 $ 664.03 $ 16.37 $ 647.66 $ 5,902.24
40 $ 664.03 $ 14.76 $ 649.27 $ 5,252.96
41 $ 664.03 $ 13.13 $ 650.90 $ 4,602.06
42 $ 664.03 $ 11.51 $ 652.52 $ 3,949.54
43 $ 664.03 $ 9.87 $ 654.16 $ 3,295.38
44 $ 664.03 $ 8.24 $ 655.79 $ 2,639.59
Four. Five $ 664.03 $ 6.60 $ 657.43 $ 1,982.16
46 $ 664.03 $ 4.96 $ 659.07 $ 1,323.09
47 $ 664.03 $ 3.31 $ 660.72 $ 662.36
48 $ 664.03 $ 1.66 $ 662.36 $ 0.00

Frequent questions

What is amortization?

The term “amortization” has two important meanings in finance. First, it can refer to the payment schedule by which a loan is gradually paid off over time, as in the case of a mortgage or car loan. Second, it may refer to the practice of expending the cost of an intangible asset over time.

Why is amortization important?

Amortization is important because it helps companies and investors understand and forecast their costs over time. In the context of loan repayment, amortization schedules provide clarity on how much of a loan payment consists of interest versus principal. This can be useful for purposes such as deducting interest payments for tax purposes. The amortization of intangible assets is also important because it can reduce a company’s taxable income and therefore its tax liability, while also giving investors a better understanding of the true profits of the company.

What is the difference between amortization and depreciation?

Amortization and depreciation are similar concepts, as they both attempt to capture the cost of holding an asset over time. The main difference between them, however, is that amortization refers to intangible assets, while depreciation refers to tangible assets. Examples of intangible assets include trademarks and patents; Tangible assets include equipment, buildings, vehicles, and other assets subject to physical wear and tear.

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Mark Holland

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