Everything You Need to Know about Amortization

Amortization is the accounting technique used to lower book values of an intangible asset or loan over a specific time period. With relation to the loan, it focuses more on spreading out the person’s loan payments with time. When applied to the asset, it’s similar (but not the same) as depreciation.

How to Understand Amortization

The single term “amortization” refers to two very different situations. You can use it to pay off your debts through interest payments and principal with time. It’s important to use an amortization schedule to reduce your current balance on the loan by using installation payments.

With that, though, amortization may also focus on spreading out the capital expenses related to specific tangible assets over a particular time frame. Usually, this happens for the asset’s useful life and is designed for tax and accounting purposes.

Loan Amortization

Sometimes, amortization refers to paying off debts using regular installments of principal and interest. With that, though, you need sufficient amounts to repay the loan entirely by the maturity date.

For auto and mortgage loan payments, more of the flat monthly payment is used on interest very early in the loan. With every payment you make, more of the amount goes toward the principal later.

You may calculate amortization using spreadsheet software, financial calculators, and online charts. If you choose an amortization schedule, it starts with the outstanding balance on the loan.

To calculate the interest payment on monthly payments, you multiply the current interest rate by the loan balance amount (outstanding) and divide that by 12. The principal amount for any month is a person’s monthly payment (flat amount) minus any interest payment.

Then, the next month, you calculate the outstanding loan balance like you did before with the balance subtracted from your most recent principal payment. Interest payments are still calculated from the new balance, so the pattern continues until every principal payment is made and the balance is at zero for the loan term’s end.

Here is the formula to help you calculate the monthly principal amount on an amortized loan:

Interest rate divided by (/) 12 months times (*) Outstanding loan balance minus (-) total monthly payment equals (=) principal payment

Usually, the lender specifies the total monthly payment you make when you get the loan. However, you can compare or estimate monthly payments based on particular factors, such as interest rate and loan amount. To do that, you might have to calculate your monthly payment, too. If this is necessary, here is the formula:

Loan Amount [i(1+i)^n/((1+i)^n)-1] = Total Monthly Payment

To figure out all of that:

  • i is the monthly interest rate. You must divide the annual interest rates by 12. Therefore, if the annual interest rate is at three percent, the monthly interest rate is 0.0025.
  • n is the number of payments you make over the lifetime of the loan. Multiply 12 by the number of years in the loan term. Therefore, a four-year car loan has 48 payments.

Intangible Asset Amortization

Amortization might also focus on intangible assets. For that, amortization helps you expense the cost of your intangible asset over the lifespan (projected) of the asset. In a sense, it measures the value consumption of your intangible asset, such as a copyright, patent, or goodwill.

You can calculate amortization similarly to depletion (natural resources) and depreciation (tangible assets).

Companies often amortize their experiences with time, and that helps them tie the cost of the asset to the revenue it might generate within the same accounting period. Therefore, a business benefits from using a long-term asset over many years. That way, the company writes off the expensive (in small increments) over the useful life of that particular asset.

It’s important to note that the IRS dictates how many years intangible and tangible assets can be used for tax purposes.

Intangibles amortization can be helpful for tax planning. The IRS allows people to take deductions for various expenses, such as:

  • Geophysical/geological expenses for natural gas and oil exploration
  • Research and development
  • Bond premiums
  • Atmospheric pollution control facilities
  • Copyrights
  • Trademarks
  • Patents
  • Forestation and reforestation
  • Lease acquisition

Amortization Example

You have a $30,000 car loan for four years at three percent interest. Therefore, your monthly payment is $664.03, which you can figure from the formula above.

That first month, $75.00 of the monthly payment goes to the interest, with the remaining balance moving to the principal.

Every month, the total payment you make stays the same. However, the principal amount increases while the interest amount decreases. During the final month of the loan, you only have to pay $1.66 for interest because the loan balance is so low compared to when you began.

Why Amortization Is Important

Amortization is crucial for investors and businesses to understand and forecast their many costs with time. For loan repayments, it offers clarity as to which portion of the payment is interest or principal. That’s useful when deducting your interest payments on your taxes.

Intangible asset amortization is also essential because it reduces the company’s taxable income, making it a tax liability. With that, investors have a good understanding of the true earnings for that business.

Depreciation vs. Amortization

Though depreciation and amortization are very similar concepts, they’re not the same. It’s true that both of these attempt to determine the cost of holding that particular asset throughout the years. However, the main difference is that depreciation is all about tangible assets while amortization is only for intangible assets.

A tangible asset could be a building, equipment, vehicles, and anything else that sees wear and tear throughout the year. However, intangible assets are patents and trademarks.

Conclusion

Most people don’t consider amortization and go by whatever the lender says. While this is okay for the most part, others want to figure out how much interest they’re paying or what to pay to reduce overall payments with time.

If you’re not sure how to handle amortization, it might be wise to contact a financial advisor. They can help you figure out what to do. With that, you may think about getting a loan or intangible asset in the future. Therefore, hiring an accountant might be wise, as well.