The world of accounting is a maze of numbers, formulas and calculations, with the goal to provide some order and balance between assets and liabilities.
One term that defines the intricacies of complex accounting is amortization, the Swiss army knife in an accountant's toolkit.
Both companies and individuals can leverage amortization to write off assets over that asset's anticipated period of usage, and create faster ways to pay off installment loans - moves that can translate into a big financial advantage.
What Is Amortization?
Amortization covers two definitions - one focused on business assets and the other focused on loan repayments.
What Is Amortization for Businesses?
Amortization is an accounting tool that essentially steers assets off of a balance sheet and onto an income statement. It does so by writing off (mostly intangible) assets over their anticipated period of use. Such assets may include copyrights, patents and trademarks.
Let's say that a company has a valuable patent, which is active for 10 years. If the business shelled out $10 million to develop the patent, then it would write down $1 million for each year as an amortization expense, and report it on the firm's income statement.
What Is Amortization for Loans?
Consumers may recognize amortization best as a term that describes the itemization of the starting balance of a loan, minus the principal and interest owed in a given time period, such as a mortgage loan or car loan. On those loans, the amortization schedule weighs interest payments on a loan much heavier in the early portion of the loan payoff period, with that interest declining throughout the life of the loan.
Let's say a high-net-worth individual has a mortgage of $1 million. If that individual repays $50,000 on an annual basis, then the borrower has amortized $50,000 of the loan every year.
For the purposes of this article, we'll examine the impact of amortization on loans, especially how it refers to the repayment of loan principal over time.
How Does Amortization Work for Loans?
Basically, amortization is a mechanism for paying down both the principal and interest on a loan, bundled into a single, fixed monthly payment. Lenders calculate amortization to the penny, so that the loan is paid off accurately, over the pre-agreed period of time. (Accountants call that time period the "term" of the loan.)
In this way, every loan payment is the exact same amount of money. Consider a 30-year mortgage loan of $165,000 over a 30-year time period, with an interest rate of 4.5%. Since amortization means the period repayment of a loan, with a specific amount going to the principal and interest payments, the amortization schedule amounts to a total fixed monthly payment of $836.03 over the life of the mortgage loan.
On a monthly basis, over 30 years, that's what it takes in real monthly payment terms to fully repay the mortgage loan.
How to Calculate Loan Amortization
As amortization is the process of paying the same amount of money on (usually) a monthly basis, the calculation for doing so depends on the principal and interest owed on the loan. The goal is to make the interest payments decline over the life of the loan, while the principal amount on the loan grows.
Here's how to do so on a step-by-step basis:
Collect all of the information on the loan needed to calculate the loan amortization schedule. Basically, all you need is the term of the loan and the payment terms. Let's calculate the amortization rate on a monthly basis, like most mortgage or auto loans.
- Find the principal portion of the loan outstanding (let's say $100,000.)
- Find the interest rate on the loan (let's say 6%).
- Find the term of the loan (let's say 360 months, or 30 years.)
- The monthly payment = $599.55
While the actual loan dollar amount is fixed, the amount you pay on a loan in terms of principal and interest is not. That's where a loan amortization schedule comes into play
To calculate amortization correctly, and find the exact balance between principal and interest payments, multiply the original loan balance by the loan's periodic interest rate. The resulting figure will be the amount of interest due on a monthly payment. At this point, you can subtract the interest payment amount from the total amount of the loan to establish the part of the loan needed to pay down the principal.
Say, for example, that you have a mortgage loan of $240,000, over 360 months, at an interest rate of 4%. Your initial monthly mortgage payment is $1,146. Your periodic interest rate stands at 0.33%, or one-12th of 4%.
Multiply $240,000 times 0.33% and you'll find that the first interest rate payment on the mortgage loan is $792. Now, take the total monthly loan of $1,146 and subtract the interest amount of $792.00 That leaves you with $354 as the amount of the monthly loan repayment that will be steered toward the principal owed on the loan.
To calculate your amortization rate going forward, take the remaining loan principal balance amount ($240,000 minus $354 = $239,646.) Then multiply $239,646 by 0.33% to ascertain your next interest payment amount. Simply repeat the calculation to figure out amortization schedules right down the line on a monthly basis.
What Kinds of Loans Can Be Amortized?
Typically, amortization schedules are used for the following loans - usually installment-based loans:
Loans that cannot be amortized include home equity loans, any revolving debt and credit cards, as those types of credit-based loans don't have fixed monthly payments.
Revolving debt and credit cards don't have the same features of an amortized loan, as they do not have set payment amounts or a fixed loan amount.
By and large, if your lender lets you know exactly how many payments you need to make to satisfy the loan, and tells you each monthly payment will be the same amount, it can be amortized. If the loan varies in total amount owed on a month by month basis, it likely cannot be amortized.
Loan Amortization Tips
To repay your amortized loans faster, and get rid of the loan altogether, make these strategies an integral part of your loan repayment plan:
- Add extra dollars to your monthly payment. If your total mortgage loan is $100,000 and your fixed monthly payment is $500, add $100 or more to each monthly mortgage payment to pay down the loan more quickly. Make sure to designate the payments as "payment toward principal" to your lender.
- Make a lump-sum payment. There's no law that says you have to spend a raise, bonus or inheritance. Use the extra cash toward your total loan amount, and significantly reduce your loan amount, and save on interest.
- Make bi-weekly payments. Instead of paying once per month on a loan, pay half the monthly loan amount every two weeks. That way you're making 13 months worth of loan payments every 12 months, thus paying down the loan more quickly and saving big bucks on interest.