By Dan Miller, WCI Contributor
Amortization is an accounting term that is used in two different (and unrelated) areas. In the first case, amortization is a process where you spread the cost of a specific asset over its useful life. The second use of the word amortization (arguably much more common, especially if you're not a business owner) refers to the way that loan payments are spread out over the course of a loan. It's important to understand how amortization works and how it compares with depreciation, which is a similar term.
For today's purposes, we're going to talk about the second use of the word and how it can affect you.
What Is Amortization?
In lending, amortization refers to the way that loan payments are calculated. In an amortized loan, the scheduled and periodic loan payments are generally the same amount each time. At the beginning of the loan, most of the payment amount goes toward paying interest on the loan with only a small amount going to paying down the principal. As the loan matures, more and more of the payment amount goes toward paying down the principal balance.
What Is Negative Amortization?
In a negative amortization loan, your regular payment is not enough to cover the amount of interest that is owed. In a regular loan, your principal balance goes down each month as you make your scheduled payment. In a negative amortization loan, your principal balance may actually go UP each month, even if you're making your regularly scheduled payments. Some types of adjustable-rate mortgages (ARMs) are negatively amortized.
What Is a Full Amortization Loan?
When a loan is fully amortized, it means that if you make all of the regularly scheduled payments, your loan will be fully paid off at the end of the term. Most mortgages and other consumer lending products (like personal loans or auto loans) are fully amortized. As long as you make all of your payments, you will end the loan with a $0 balance.
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How Does Amortization Work?
In an amortized loan, your regular payment is divided into two components: interest and principal. Part of your payment goes to paying the interest due on the loan, and the rest pays down the balance of your principal. Each month, as you pay down your principal balance, the amount of interest decreases, which means that you pay more and more toward your principal.
Amortization Example
Here is an amortization example of a 30-year mortgage of $500,000 at an annual interest rate of 6%. On this loan, you will make 360 monthly payments of $2,997.75. The first month of the loan, $2,500 of that amount will be interest with only $497.75 going to paying down the principal. In the second monthly payment, $500.24 will go toward the principal, and the amount going to principal increases each month until the 360th and final payment, where the loan is completely paid off.
Amortization Table
Here is a look at some of the amortization table for the above example with a 30-year mortgage of $500,000 at an annual interest rate of 6%.
The amount going to the principal goes up and the amount going to interest goes down (along with the remaining balance) with each payment, until the end of the loan.
How to Calculate Amortization
To calculate amortization, first calculate the monthly interest owed on the total outstanding principal amount. In our example above, $500,000 * 6% / 12 is $2,500, which matches the amount of interest owed on the first payment. The remaining amount of the payment goes toward paying down the principal balance. The exact calculations to determine what the total payment amount should be are a bit more mathematically intense, but thankfully there are many free amortization calculators out there that you can use.
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Types of Amortizing Loans
Here are a few common types of amortizing loans:
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- Fixed-rate mortgages
- Home equity loans
- Auto loans
- Personal loans
- Student loans
Difference Between Amortization and Depreciation
Besides its use in lending, the term amortization also refers to the accounting practice of spreading the cost of an asset over its scheduled life. Depreciation also refers to spreading the cost of an asset over its useful life, but the difference between amortization and depreciation comes with the type of asset. Amortization is used to spread the cost of an intangible asset, such as a trademark, copyright, patent, or franchise agreement. Depreciation is used for fixed and tangible assets like buildings, equipment, vehicles, or office furniture.
What Is Accumulated Amortization?
Each year, you may amortize a certain amount for each intangible asset you or your business own, so you will want to keep track of the accumulated amortization. Accumulated amortization simply refers to the total amount of amortization that has been charged against a given asset.
Benefits of Amortization, Why Is Amortization Important?
One of the main reasons the amortization of intangible assets is important is that you could take a tax deduction for the amortization amount, referencing the fact that the value of many intangible assets declines over time. Another benefit of amortization is that it gives a fixed deduction each year, which may help to simplify your accounting and balance sheet.
The Bottom Line
Amortization is an important accounting term that has two separate (and very different definitions). In lending, it refers to the way that payments are calculated on a loan. At the beginning of an amortized loan, most of your payment goes toward paying interest, and with each payment, the amount that goes toward paying down the loan principal increases. In business, amortization refers to the practice of spreading the cost of an intangible asset over its scheduled life. Being aware of these two forms of amortization can help you increase your understanding of finance and accounting—and that should be in the interest of every white coat investor.
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