Amortization Explained

Keep hearing about this amortization process, but not really sure what that means? Continue reading as we explain to you what it means to get your loan amortized.  

If you’re like most people, the word “amortization” probably doesn’t mean much to you. But if you’re in the process of taking out a loan, it’s a term you’ll want to get familiar with.  

The meaning of amortization is basically to signify the process of spreading out a loan over a period of time. You essentially pay a portion of the principal (which is the amount you borrowed) and a portion of the interest with each payment you make.  

As time passes, the portion of each payment that goes to the principal increases with your payments, while the portion that goes to interest decreases. Eventually, if you make all your payments on time and in full, you will no longer owe anything.  

This can be a helpful way to budget your loan payments because you’ll know exactly how much of your payment will go towards the principal and how much will go towards interest. It can also help you keep track of your progress in paying off the loan.  

Understanding amortization can help you make rational repayment decisions if you’re thinking about taking out a loan or currently have one.  

What Exactly Is Amortization?

An amortization loan is a process of spreading out the payments into equal parts over its life. In accounting, amortization refers to the writing off of an intangible asset’s value over time. Amortization is also often used in the context of mortgages, where it refers to the process of paying off a mortgage loan through regular payments.  

Mortgage amortization loans are typically distributed over a period of 15 or 30 years. With a 15-year mortgage loan, for example, the borrower would make 180 monthly payments (15 years x 12 months). Since the borrower will be paying off the loan sooner than with a 30-year mortgage loan, the monthly payment will be higher.  

An amortized loan’s monthly payment consists of both principal and interest. The majority of the payment for an amortized loan goes toward interest in the initial years. This is due to the fact that the borrower has not yet paid off much of the principal balance. As the loan is repaid, less and less of the payment goes to interest, and more and more goes to the principal even though the monthly payment stays the same.  

How Does Amortization Work?

As we already explained. Amortization is the process of scheduling out a fixed-rate loan into equal payments.  

For a wide range of loans, including mortgages, auto loans, student loans, and business loans, amortization schedules can easily be made. The schedule will specify how much of each payment will be applied to the principle and how much will be applied to interest.  

After creating this schedule, you will get a clear picture of what your payment goes towards. So, you are still making the same amount on a payment every month but after you paid a significant portion, there will be less balance that you need to pay off and therefore less amount to be calculated into interest.  

Example of Amortization

Now that we covered what this process is, we will provide you with an example so if you are having difficulties understanding this, it can help. 

So, let’s now look into the amortization table monthly payment.   

After 5 years, you would have paid half of the loan amount, so on the remaining amount, the interest would still be 5%, but 5% from $5,000 is just $250 as opposed to $500 for $10,000. The payment will stay the same, but this little interest would be spread out through monthly installments.  

We hope you now understand what we meant when we said the payment stays the same but more goes into principle. By understanding how amortization works, you can make the best decisions about the way you want your loan balance to be repaid.  

The example we gave you may not be that well applicable for your situation so we suggest you check out the amortization calculator that can be found online so you can get exact numbers for your loan deal.  

Amortization vs. Depreciation: What’s the Difference?

Many people mix up amortization with depreciation when referring to company expenses. There are several significant differences between the two, despite the fact that both are used to spread the expense of an asset throughout its lifetime. Here are the basic differences between depreciation and amortization:  

Amortization can be used for intangible assets, while depreciation is used for tangible assets.  

Amortization is based on the expected life of an asset, while depreciation on the other hand is based on the actual lifespan of an asset. Amortization also involves regular payments, while depreciation is actually a one-time expense. In addition, there is a difference in how they are recorded. Amortization is recorded as an expense on the income statement, while depreciation is recorded as a contra asset on the balance sheet.   

You may take advantage of both depreciation and amortization when it comes to business expenses but in order to do so, you need to be aware of these key distinctions we mentioned.

Is It Possible to Amortize Intangible Assets?

Intangible assets could in fact be amortized. However, there are a few crucial things to remember when doing so. First, it is often more challenging to value intangible assets than tangible ones. Making an accurate amortization schedule can therefore be more difficult. Second, compared to tangible assets, intangible assets may be subject to different tax treatment. To be sure you are properly accounting for any tax implications of amortizing intangible assets, we recommend you speak with a tax advisor. 

Bottom Line

In conclusion, when it comes to amortization, this whole process of spreading out the cost of an asset over the life of a loan can be really useful. By doing this, businesses can better manage their finances and make decisions about future purchases. Even if you are not a business owner, don’t overlook the importance of amortized loans, as almost any type of loan out there can go through this process. Amortization can be a complex topic, but knowing the basics can help you make better-informed decisions for your finances.