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Amortization

The act of paying off a debt through scheduled, pre-determined smaller payments

What is Amortization?

Amortization refers to the act of paying off a debt through scheduled, pre-determined smaller payments. In almost every area where the term amortization is applicable, these payments are made in the form of principal and interest. The term is closely related to the concept of depreciation.

 

Amortization

 

Amortization is a Fundamental Concept of Accounting, learn more with our Free Accounting Fundamentals Course.

 

Amortization of a Loan

The amortization of a loan means that the loan is paid back, in full, over time. 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 payments on the loan will be different from one month to the next; however, the same total amount must be paid each payment period. With items such as home or auto loans, payments made consist of parts that change over the course of repayment. Regardless, each payment made goes toward the interest on the loan and reduction of the total balance of the loan.

Interest costs are always highest at the beginning so that the bank or lender is compensated for their trouble as quickly as possible. 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 depreciation of such assets, over time, as marked by a company’s accounting team.

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, meaning, 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 assets that aren’t physical. It is arguably more difficult to calculate because the true cost and value of things like intellectual property and brand recognition are not set in stone. It takes a responsible, well-rounded accountant working closely with a company to help the business understand what its intangible assets are worth and how to account for the depreciation of the assets over time.

Regardless of which specific instance it refers to, amortization means the writing off of cost. 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.

 

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. The following resources will be helpful in furthering your financial education:

  • Floating Interest Rate
  • Loan Covenant
  • Prepayment
  • Standby Fee

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