What is Amortization
Amortization is a financial accounting practice applied to intangible assets and loan repayments. It involves spreading the cost of intangible assets, such as patents, copyrights, and franchise agreements, over their expected useful life.
This ensures that the expense associated with these assets is recognized gradually over time rather than all at once. Amortization is also utilized in the context of loan repayment schedules, where it helps borrowers systematically reduce their outstanding loan balances.
Why is it Important?
Amortization is crucial for several reasons:
- Systematic Expense Recognition: It ensures that the cost of intangible assets is recognized in a structured manner over their useful life, aligning with the matching principle in accounting.
- Financial Planning: Amortization assists businesses and individuals in planning their finances by providing a clear picture of future expenses related to intangible assets and loan repayments.
- Risk Management: By amortizing intangible assets, businesses can reduce the risk of sudden financial hits caused by large, one-time expenses.
- Loan Management: In the context of loans, amortization helps borrowers understand the composition of their payments, making it easier to track principal and interest amounts.
Different Types of Amortization
- Straight-line: Interest is evenly distributed throughout the loan amount, ensuring simplicity in accounting.
- Annuity: Equal payments are made at regular intervals.
- Declining Balance: Payments exceed interest, leading to a gradual reduction in the loan balance.
- Bullet: Regular payments cover only interest, with a lump-sum payment due at the term’s end.
- Negative Amortization: Payments are lower than the interest rate.
How to Calculate Amortization with Formula
Calculating amortization involves determining principal payments using the formula:
Principal Payment = Total Monthly Payment – (Outstanding Loan Balance × Monthly Interest Rate)
Additionally, the Total Payment formula accounts for the full repayment amount over the loan term:
Total Payment = Loan Amount × [(1 + Monthly Interest Rate)^n – 1] / [Monthly Interest Rate × (1 + Monthly Interest Rate)^n]
Where:
Monthly Interest Rate: Monthly interest rate in decimal form.
n: Number of payments.
Alternatively, online loan amortization calculators simplify this process.
Benefits of applying Amortization
Amortization offers several advantages:
- Reduced Investment Risk: Gradual expense recognition reduces the financial risk associated with intangible assets, making financial planning more predictable.
- Fixed Repayment Schedule: In loan contexts, amortization provides borrowers with fixed, manageable repayment schedules, making it easier to budget for loan payments.
- Loan Comparison: It enables borrowers to compare different loan options, such as varying amortization schedules, to select the one that best suits their financial situation.
- Debt Management: Amortization allows borrowers to assess potential savings by paying off debt early, motivating responsible debt management.
In summary, amortization is a critical financial concept that applies to both intangible assets and loan repayment structures. It ensures that expenses and payments are spread out over time, providing financial stability and predictability while allowing for better debt management and investment risk reduction.
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What?
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Amortization is the accounting practice of spreading the cost of an intangible asset over its useful life. Intangible assets are not physical in nature but they are, nonetheless, assets of value. Examples of intangible assets that are expensed through amortization include patents, trademarks, franchise agreements, copyrights, costs of issuing bonds to raise capital, or organizational costs.
Amortization is typically expensed on a straight-line basis. That means that the same amount is expensed in each period over the asset’s useful life. Assets that are expensed using the amortization method typically don’t have any resale or salvage value.
The term “amortization” is used in another, unrelated, context. An amortization schedule is often used to calculate a series of loan payments consisting of both principal and interest in each payment, as in the case of a mortgage. Though different, the concept is somewhat similar; as a loan is an intangible item, amortization is the reduction in the carrying value of the balance.
What is Amortization Expense?
Amortization expense is the write-off of an intangible asset over its expected period of use, which reflects the consumption of the asset. This write-off results in the residual asset balance declining over time.
- Accounting for Amortization Expense
Amortization is almost always calculated on a straight-line basis. Accelerated amortization methods make little sense, since it is difficult to prove that intangible assets are used more quickly in the early years of their useful lives. The accounting for amortization expense is a debit to the amortization expense account and a credit to the accumulated amortization account.
- Presentation of Amortization Expense
The amount of an amortization expense write-off appears in the income statement, usually within the “depreciation and amortization” line item. The accumulated amortization account appears on the balance sheet as a contra account, and is paired with and positioned after the intangible assets line item. In some balance sheets, it may be aggregated with the accumulated depreciation line item, so only the net balance is reported.
Examples of Intangible Assets
Amortization is most commonly used for the gradual write-down of intangible assets. Examples of intangible assets are broadcast licenses, copyrights, patents, taxi licenses, and trademarks.
Example of Amortization Expense
ABC Corporation spends $40,000 to acquire a taxi license that will expire and be put up for auction in five years. This is an intangible asset, and should be amortized over the five years prior to its expiration date. The annual journal entry is a debit of $8,000 to the amortization expense account and a credit of $8,000 to the accumulated amortization account.
The rate at which amortization is charged to expense in the example would be increased if the auction date were to be held on an earlier date, since the useful life of the asset would then be reduced.
- Real Estate
- Full Amortization: You pay the amortization amount, making the balance zero at the end of the term.
- Partial Amortization: Your monthly amount is reduced when you make a partial payment of the amortization amount. You will also have an outstanding balance at the end of your loan term.
- Interest Only: You only pay the interest without making payments towards the amortization amount. Thus, you will have the principal amount outstanding at the end of the term, as it was at the start.
- Negative Amortization: You make monthly payments lower than the interest rate. At the end of the term, you will have a larger amount than the principal amount.
Straight-line: It is also referred to as linear amortization. You distribute the interest amount equally throughout the loan amount. It’s a preferred accounting method, owing to its simplicity.
- Annuity: You pay equal amounts at equal intervals.
- Declining Balance: Each payment you make is more than the interest, and the balance amount of the loan gradually decreases.
- Bullet: You make regular payments that only include the interest amount. Eventually, you pay a big-ticket amount at the end of the tenure.
- Negative Amortization: It is similar to negative amortization for real estate.
How to Calculate Amortization?
a) Formula
Here’s the generally accepted formula for calculating amortization:
Principal Payment = TMP − (OLB × 12 Months / Interest Rate)
Where:
TMP is the total monthly payment.
OLB is the outstanding loan balance.
Total Payment = Loan Amount × [(1+i) n−1i×(1+i) n]
Where:
i, is the monthly interest payment.
n is the number of payments.
b) Calculation:
Here’s a step-by-step process to calculate amortization:
- Calculate the first month’s interest and principal amount.
- Gather all the information you need to calculate the amortization of the loan
- Calculate the interest on the monthly payment for one month.
- Calculate the principal amount for one month
- Use the new principal amount at the end of the first month to calculate amortization for the second month
- Determine the principal repayment for the second month
- Next, calculate the amortization for the entire term of the loan
- To avoid the complicated mathematical calculation, you can also make use of any of the online loan amortization calculators
What is an Example of Amortization?
For example, you have a loan outstanding amounting to Rs.50,000. If you pay Rs. 10,000 of the principal yearly, Rs.10,000 of the loan amount has been amortized yearly. Furthermore, you should record Rs.10,000 in your books as an amortization expense each year.
What are the Benefits of Amortization?
Listed below are the primary benefits of amortization:
- Amortization has a comparatively low investment risk
- The repayment schedule is fixed
- The amortization table helps in evaluating multiple loan options
- You can calculate how much you would potentially save by paying off your debt early
Why Should You Opt for Amortization?
Consider paying back a loan without a repayment schedule. Making a one-time payment towards the final repayment of the loan could be practically impossible, considering the huge amount of principal and interest, especially in loans like a home or a car.
Repayment of large sums of payments towards a loan can also set your personal and financial objectives back for years. You can better organise your finances by managing huge loan repayments with amortization. This repayment method also gives the management of your debt top priority.
