Amortization is a term commonly used in finance and accounting. It has a variety of meanings depending on the context of its use.
The term is used to express the liquidation of an interest-bearing debt through a series of periodic payments (usually equal) over a certain period. This is common when taking out a loan or a mortgage.
The verb is to amortize. According to Oxford Dictionaries, to amortize is to:
“Gradually write off the initial cost of (an asset) over a period.”
Amortization can refer to the process of paying off a mortgage over time through regular payments.
In accounting, amortization refers to the assignment of a balance sheet item as either revenue or expense on an income statement.
Amortization also refers to a business spreading out capital expenses for intangible assets over a certain period for tax and accounting reasons. In a sense it is similar to depreciation. It estimates an asset’s expense with how much revenue it brings in.
Amortization of loans
An amortization schedule determines the distribution of payments of loan into cash flow installments. As opposed to other models, the amortization model is composed of both the interest and the principal.
It is considered to be one of the simplest repayment models as the payments are split into equal amounts during the loans lifetime.
Typically more money is applied to interest at the start of the schedule, and more money is applied to principal towards the end.
A loan is amortized when part of each payment is used to pay interest and the remaining part is used to reduce the outstanding principal. Over time, through the series of payments, the outstanding principal is gradually reduced and interest on the unpaid balance falls.
Once a debt is amortized by equal payments at equal payment intervals, the debt becomes the discounted value of an annuity.
Amortization tables are used to represent the composition of periodic payments between interest charges and principal repayments.
Negative amortization can occur if the payments fail to match the interest. In this case then outstanding interest is added to the total loan balance – making the total loan amount larger than how much it was originally.
The Amortization Schedule Formula:
A = payment amount per period
P = initial principal (loan amount)
r = interest rate per period
n = total number of payments or periods
How to calculate the amortization of a loan
If you have a loan you can calculate the payoff schedule as long as you know the starting amount of the loan, the term of the loan, and the total number of payments necessary. An amortization table provides you with the principal and interest of each payment.
Assume that you have a 10 year loan of $10,000 paid on a monthly basis with an annual percentage interest rate of 5%.
Step 1: Find out how many loan payments you will make in total.
In the example above the loan is paid on a monthly basis over 10 years, therefore there is a total of (12 x 10) 120 loan payments.
Step 2: Calculate the period interest rate.
To calculate the period interest rate you divided the annual percentage rate by the number of payments in a year. In the example payments are made on a monthly basis, which is equal to 12 payments in a year, and the annual rate is 5%. Therefore, the period interest rate would be (0.05/12) = 0.0041666, or 0.41667%.
Step 3: Use the amortization schedule formula to calculate the payment for each period.
In our example the loan amount is $10,000. Our period interest rate is 0.00417. Our total number of payments is 120.
Amount per period = (10,000)*[(0.004166)((1+0.004166)^120)]/[(((1+0.004166)^120) -1)]
Step 4: Draw a table.
Draw three columns, with the first column titled “Current Value”, the second column titled “Interest”, and the third column titled “Principal”.
In this example you would write $10,000 at the top of the Current Value column.
Step 5: Calculate the Interest and Principal values and add them to your table.
Multiply the current loan value by the period interest rate to get the interest and subtract the interest from the payment value to get the principal.
The “Interest” in the example would be: $10,000 * 0.00417 = $41.7
The Principal would be: $106.08 – $41.7 = 64.40
Step 6: Subtract the principal from the current value and write the new current value in the second row of the “current value” column.
$10,000 – 64.40 = $9935.60
Step 7: Repeat steps 5 and 6.
In our example the table would look like this (note that it is not complete and only shows up to the 19th payment):
Video – What is Amortization
Amortization of intangible assets
Amortization also refers to the acquisition cost of intangible assets minus its residual value, which reflects its consumption and subsequent decline in value over time.
There are some intangible assets that are not subject to amortization, including goodwill, which are considered not to have a set period of “life”.
Amortization of intangible assets are recorded in the financial statements (such as an annual report) of a company as an expense.