What is Amortization?
Amortization refers to the process of paying off a debt through scheduled, pre-determined installments that include principal and interest. In almost every area where the term amortization is applicable, the payments are made in the form of principal and interest.
Such usage of the term relates to debt or loans, but it is also used in the process of periodically lowering the value of intangible assets much like the concept of depreciation.
Amortization is a fundamental concept of accounting; learn more with our Free Accounting Fundamentals Course.
Amortization of a Loan
The amortization of a loan is the process to pay back, in full, over time the outstanding balance. In most cases, when a loan is given, a series of fixed payments is established at the outset, and the individual who receives the loan is responsible for meeting each of the payments.
The principal and interest amounts paid on the loan will vary from one month to the next; while the payment amount will be fixed each payment period. The fact is illustrated below in Figure 1:
Figure 1 illustrates an equal payment loan. As shown, the total payment for each period remains consistent at $1,113.27 while the interest payment decreases and the principal payment increases.
Interest costs are always highest at the beginning because the outstanding balance or principle outstanding is at its largest amount. It also serves as an incentive for the loan recipient to get the loan paid off in full. As time progresses, more of each payment made goes toward the principal balance of the loan, meaning less and less goes toward interest.
Not all loans are designed in the same way, and much depends on who is receiving the loan, who is extending the loan, and what the loan is for. However, amortized loans are popular with both lenders and recipients because they are designed to be paid off entirely within a certain amount of time. It ensures that the recipient does not become weighed down with debt and the lender is paid back in a timely way.
Amortization of Assets
Amortization means something different when dealing with assets, specifically intangible assets, which are not physical, such as branding, intellectual property, and trademarks. In this setting, amortization is the periodic reduction in value over time, similar to depreciation of fixed assets.
When fixed/tangible assets (machinery, land, buildings) are purchased and used, they decrease in value over time. So, for example, if a new company purchases a forklift for $30,000 to use in their logging businesses, it will not be worth the same amount five or ten years later. Still, the asset needs to be accounted for on the company’s balance sheet.
Depreciation is determined by dividing the asset’s initial cost by its useful life, or the amount of time it is reasonable to consider the asset useful before needing to be replaced. So, if the forklift’s useful life is deemed to be ten years, it would depreciate $3,000 in value every year.
Amortization refers to the act of depreciation when it comes to intangible assets. It is arguably more difficult to calculate because the true cost and value of things like intellectual property and brand recognition are not fixed. Accounting and tax rules provide guidance to accountants on how to account for the depreciation of the assets over time.
Regardless of whether you are referring to the amortization of a loan or of an intangible asset, it refers to the periodic lowering of the book value over a set period of time. Having a great accountant or loan officer with a solid understanding of the specific needs of the company or individual he or she works for makes the process of amortization a simple one.
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