Financial literacy is an important aspect for every individual who wishes to take control of their finances right away. A solid financial education is essential to everyone including those from non-finance backgrounds to get value for their money and avoid overexploitation by some of the financial institutions. Especially with loans and mortgages, borrowers should know the amount owed in loans and the value of their assets. The key to finding out all the information about loans and assets such as mortgages is understanding the concept of amortization. Amortization is a popular term, but in case this is your first time coming across it, this article will help you understand the nitty-gritty of the concept.
What is amortization?
Amortization is a simple financial term that refers to the act of spreading the cost of a big item over time, as financial institutions do with mortgages and banks. So, let’s say you walk into a bank and request a loan, the bank approves a substantial amount that you are required to pay in smaller amounts every month. That is the meaning of amortization. Simple. Right? Maybe as a beginner you pictured such a scenario before but might have lacked the correct term to describe it. Well as explained, amortization requires the borrower to pay the principal amount and the interest accrued over time, so that by the end of a certain duration, they pay off the entire debt. The term applies to loans and mortgages.
Amortization vs depreciation
Many times the two terms bring confusion for beginners and experts. Since amortization involves spreading the cost of an asset over time many think it has the same end product as depreciation. Notably, depreciation is the gradual reduction in the asset’s value over its useful life. On the other hand, amortization is dividing the cost into smaller manageable amounts to repay over time. In simple terms, depreciation is concerned with calculating the value of an item over a specific period while amortization deals with the cost needed to pay to reduce the value to manageable levels.
Types of amortization
There are two types of amortization-intangible asset and loan amortization. Each is different but both are significant for efficient financial management.
Amortization of assets
Amortization of assets involves expensing the cost of an item over a specific period. In most cases, individuals amortize their intangible assets such as trademarks, goodwill, and patents. These are assets which are not physical in nature.
Here is a simple guideline to calculate the amortization of an intangible asset:
Start by getting the annual amortization. Annual amortization is calculated by dividing the initial cost by the estimated period in which the intangible asset will still be useful (For instance, for an intangible asset that costs $345 with a useful life of 5 years, divide $345/5 years).
Get the outcome. Calculate the outcome of the first year, for instance, the intangible asset is amortized at $69 per year.
Calculate the amortization for the subsequent years. An intangible good is usually amortized several years down the line. Interestingly, the amortization of the first year can be used to calculate the amortization of the subsequent years i.e. second year, $138, third year, $207, and so on until the amount paid is reached.
Amortization of loans
Loan amortization involves breaking down a loan into fixed payments over time. The borrower pays a fixed amount so that by the time they finish the interest also they have managed to pay the principal amounts separately. Depending on the terms specified in the loan agreement, the first few months require a borrower to pay monthly interest, and in the last few months to pay for the principal amount. Car loans and mortgages are some of the most common types of amortized loans.
The procedure for calculating loan amortization is as follows:
Calculating the declining balance: The approach requires the borrower to pay off some debt at the beginning to lower the interest so that the financial institution reduces installments further down the line.
Increasing balance: In this method, installments begin while low but increase with time. The method is ideal for borrowers experiencing financial difficulties at the beginning but anticipates greater repayment capabilities in the future.
The French method: Involves paying back the same amount monthly until the debt is fully cleared. In the French method, the installments remain the same while the borrower owes interest at the beginning so they can complete the principal later.
Benefits of Amortization
The good news is that by amortizing loans and assets there are several benefits that a borrower can accrue. These benefits are as follows:
Improved cash flow: The method frees up cash in the short term giving the borrower less burden and an opportunity to invest in other areas.
Predictable payments: Amortization allows you to predict payments, so you accurately plan and forecast expenses. In most instances with predictable payment patterns, the borrower is less likely to be taken advantage of because if they realize any mistake they quickly raise an alarm.
Tax benefits: Amortized intangible assets are treated as expenses that can be deducted as taxable income.
Drawbacks of amortization
Although amortization has its benefits, the practice exposes the borrower to several risks. These risks are as follows:
High interest payments: During amortization, the interest rates paid are still high in the early stages resulting in a situation whereby the bulk of the payments go towards reducing the interest rather than the principal amount.
Long-term repayment schedules: Most instances of amortization schedules take time to fully pay a loan which can prolong the burden on the borrower.
Conclusion
In a nutshell, amortization is an essential financial concept everyone needs to understand. The focus is on spreading the cost of a loan or an intangible asset over time to reduce hefty expenses. An understanding of this concept is useful in making informed financial decisions so that borrowers can plan and manage finances wisely. Talk to your financial partners today regarding amortization and its benefits, to begin a journey of financial breakthrough.