Amortization refers to making use of a fixed repayment schedule to pay off debt, usually in regular instalments over a given duration. It also refers to the distribution of capital expenses for non-physical (intangible) assets over a pre-arranged time-line, i.e. the duration for which the asset remains useful, for tax and accounting purposes.
There is a similarity between amortization and depreciation, which applies to intangible assets, and to depletion, which applies to natural resources. Amortized expenses helps businesses to combine the cost of an asset with its generated revenue. For instance, if a company buys a carton of staple pins, the cost of pins is written off in the year of purchased, and usually uses up all of the pins in the same year. On the other hand, using a bigger asset, the rewards from such expense last for a longer time, therefore the cost is written off incrementally for more years.
Amortization occurs when a debt is paid off over a period of time with equal, regular payments. With each payment, usually monthly payments, a share of the money is used as interest costs, which is what the lender is paid for the loan, and another to reducing loan balance, i.e. paying off the loan principal.
At the start of the loan, interest costs are at their highest levels, especially if the loans are long-term ones. Most of the periodic payments made then are interest expenses, and only a small piece of the balance is paid off. With time, more of each deposit goes towards the principal, and less interest is paid each month.
One characteristic of amortised loans is that after a fixed amount of time, the last loan payment is designed to completely pay off the balance for the loan. This means that a 20-year mortgage will be paid off after exactly 20 years.
In terms of a house purchase, amortization refers to the process whereby loan principal gets lower over the duration of the loan, i.e. n amortizing loan. With each mortgage payment, some of the payment serves as interest on the loan, while what is left-over of the payment is used for reducing the principal.
A payment table, called an amortization schedule, is used to indicate each payment on the loan, and it shows the amounts of principal and interest that have been paid and that are remaining. It also shows how a loan’s principal amount reduces with time. An amortization calculator is used to generate the amortization schedule table.
For home loan payments and auto loans, most of the monthly payment goes towards interest at the beginning of the loan term. With each ensuing payment, a larger percentage of the payment is made towards the loan’s principal.
Calculations of amortized loans can be made by building a personal amortization table, using an online calculator or using spreadsheets for analysis.
With an amortizing loan, the payment depends on the cost of the loan, interest rate, and duration for the loan. These requirements work together to influence the amount that needs to be paid monthly, and the total interest payable.
A lower interest rate will mean less payments to be made, thereby saving money. When the loan is stretched out over a longer period of time, payment is also reduced, but the result will be a larger amount to be paid in interest for the loan’s lifespan.
Personal loans gotten from a bank, online lender or a credit union are usually amortized loans. They usually offer three-year terms, interest rates that are fixed, and fixed monthly payments too. Personal loans are generally used for small projects or for consolidation of debts,
Auto loans, which are often five-year (or less) amortized loans paid with a fixed monthly payment. Certain individuals, such as buyers and auto dealers consider buying an auto in terms of only the monthly payment. Longer loans are also possible, but present the risk of having upside-down loans.
Home loans are generally fixed rate mortgages spanning 15 years or 30 years for others. These loans work even if the home is sold or the loan is refinanced; because most people do not keep loans or that long.
Credit cards, interest only loans and balloon loans are not amortising loans. Credit card loans are known as revolving debt, offering the option of borrowing over and over on the same card. Interest only loans do not amortize, especially at the beginning. Balloon loans require a large principal payment, with small payments made during the early years of the loan. When the entire loan becomes due, the options are to refinance, or pay off the whole loan.
Taxpayers are allowed by the IRS to take a deduction for some amortized expenses such as: research and development, lease acquisition, bond premiums, geological and geophysical expenses spent in exploration of oil and gas, forestation and reforestation and atmospheric pollution control facilities. Other intangible expenses ae also included such as goodwill, trademarks and copyrights.
Most latest financial calculators, spreadsheet software packages such as Microsoft Excel, or amortization charts and tables can be used to easily calculate amortization. In order to deduct amortization costs, tax filers are required by the IRS to complete Part VI of Form 4563. There are schedules used by the IRS which dictate the percentage of an asset’s cost that can be amortised by a business in a year. The schedules divide intangible assets into categories, having slightly differing amortization rates.
Carrying out amortization for business capital expenses creates a more precise view of the financial health of the company. A company that writes off the entire cost of its expenses in their purchase year creates a huge vacuum as the large amount reduces the company’s revenue for that year, making it seem as if the company made little earnings. However, by distributing the expense over several years, the true cost of doing business is displayed by the company’s ledger. In addition, tax liability s more consistent for the company.
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