Amortization: A Structured Financial Repayment Plan

Amortization is the process by which an asset’s cost is gradually written off or a debt is paid off with regular payments. In business, when initial costs are amortized it mitigates the risk of having to deal with negative working capital. In real estate, when people have a mortgage, amortization enables them to own the property when the loan term is completed. An amortization schedule provides a look at the monthly payments and how they will reduce the amount owed on a piece of real estate or any other type of asset. Through amortization, money owed is systematically paid off.

Amortization In Business

When the term amortization is used in business, it generally refers to the spreading out of payments over multiple periods of time. Amortization can be used tp pay off loans or to pay for assets. When the term amortization is used with assets, it refers to allocating an intangible asset’s cost over a specific period of time. When it comes to lending, amortization refers to distributing loan repayments into installments based on an amortization schedule. But, unlike other repayment models, with amortization each payment is applied to both the principal as well as the interest.

A Preferred Repayment Model

Amortization is considered to be the simplest repayment model. It’s primarily used for loan repayment. Each payment is divided into equal amounts throughout the loan’s duration. However, the amortization schedule can start with more of the payment being applied to interest and a greater percentage of the payment going to the principle at the end. This is commonly known as Equated Monthly Installment or EMI. A mortgage loan is a common example of this. Borrowers like it because they know exactly what their monthly payments will be and it lets them systematically pay off their loans.

Negative Amortization

When the payments that debtors make doesn’t cover the interest that’s due on the loan, that’s called negative amortization or deferred interest. The remaining interest is added to the loan’s outstanding balance. That can make the total money owed larger than the original amount of the loan. With fully amortized loans, the last payment is the same as all the others and pays off both the principle and the interest. In loan repayment models that are not fully amortized, the borrower can end up being required to make a large balloon payment to cover all the remaining principal and interest or be in default.

Amortization In Accounting

In accounting, the term amortization refers to the expensing of acquisition costs minus the asset’s residual value. This is done systematically over the asset’s estimated ‘useful economic life’ to reflect its expiry, consumption, obsolescence and other things that cause a decline in value due to use or the passage of time. This is called asset depreciation. Methodologies that can be used to allocate amortization to each period’s accounting are the same as the ones for depreciation. On the other hand, many assets have a useful life span that is indefinite and not subject to depreciation.

Amortization And Intangible Assets

Theoretically amortization can be used to account for intangible assets’ decreasing value over their useful life. However, in practice a large number of companies tend to amortize costs that would be otherwise considered one-time expenses by listing them on cash flow statements as capital expenses. They then use amortization to pay off the costs. This has the effect of improving net income on quarterly or fiscal year expense accounts. On financial statements amortization is recorded as a reduction in intangible assets’ carrying value on balance sheets and on income statements as an expense.

Amortized Financing

Both corporate and personal clients have two primary sources of financing. They are debt and equity. Financial institutions loan businesses and individuals money through debt financing. The amount borrowed is called a loan. And the lender is repaid using pre-decided payment terms. Businesses use debt financing when paying for their product research, land, plants and machinery. Private individuals use bank loans to purchase cars, real estate and other ‘big ticket’ items. Businesses and individuals pay interest on those amortized loans until the principal and interest are repaid within a specified period of time with monthly payments.

Loan Amortization

Amortization is used for loans and business intangibles. For the business intangibles, an amortization schedule divides the intangible assets value over its useful life. With loans, however, there is a different payment structure. In paying the loans back, every scheduled installment payment consists of accrued interest and the principal amount. In each period, the interest’s fixed rate is deducted from each pre-scheduled installment payment. The remaining amount becomes part of the principal. By the end of the loan’s amortization schedule, the borrower will have completely repaid the loan.

Types Of Amortizing Loans

Only certain types of loans can be amortized. In personal finance, they include:

Home Loans
Personal Loans
Auto Loans
Student Loans

The home loans usually are fixed-mortgage loans and the borrower pays a fixed interest rate for 15 to 30 years regardless of fluctuations in the marketplace. Some lenders also offer flexible-rate mortgages where the interest rate can go up or down depending on changes in the marketplace. Personal loans are usually amortized with a payment period of three to five years. Auto loans have amortized loan repayment schedules and require a down payment and about five years of payments that combine the principal and the interest owed. Amortized student loans from private lenders tend to have higher interest rates than loans from the federal government with subsidized rates.

Non-Amortized Loans

There are a number of types of loans that are not amortized. They include:

Balloon Loans
Credit Card Loans
Interest-Only Loans

These are types of loans do not have a set repayment schedule and the payment amount can be dramatically different from one period to the next. Plus, the percentage of the payment that covers the principal and the interest can also change during the repayment period. This can create a certain level of uncertainty for the borrower.