What Is Amortization?
Amortization calculates how loans (like fixed-rate mortgages) are allocated towards principal and interest payments over the loan term.
It may also refer to an accounting method that expenses the cost of an intangible asset over time on a company’s financial statements. Note: Amortization in accounting is covered below.
Amortization and Interest: How Are They Related?
Amortization and interest are related based on loan calculations. An amortized loan has equal monthly payments throughout the loan term, with a set percent of interest paid and the remainder applied towards the principal. As the loan balance decreases, the amount of interest that is paid each month also decreases. These monthly interest allocations control the loan balance amortization.
Are All Loans Amortized?
Not all loans are amortized.
Loans that have fixed monthly payments (also known as installment loans) are amortized. A portion of each payment is allocated towards principal and interest.
Examples of amortized loans include:
Home equity loans
When Does Amortization Start?
Amortization begins as soon as there is an outstanding loan balance. Starting with the first payment, an amortization schedule is calculated by dividing the fixed monthly payments into allocations toward principal and interest. Over the loan term, principal payments increase and interest payments decrease (but the monthly payment remains the same).
An amortization schedule is illustrated as a table with multiple columns. Each column in the amortization table displays information about the monthly payment, total interest, principal, and the loan balance.
Below is an example of an amortization table for a $5,000 loan at 3% annual interest with a 1-year maturity. With each subsequent month, the monthly payment stays the same, but the loan balance decreases. The amount paid towards interest also decreases while the amount paid towards principal increases.
How Do You Calculate Amortization?
To calculate amortization for a fixed-rate mortgage, input the mortgage amount, term, and annual interest rate into the InvestingAnswers amortization schedule calculator. It uses this data to provide a table that shows interest and principal paid to the lender each month, as well as the outstanding mortgage balance at any point during the life of the loan.
Should I Worry About Amortization if I’m Paying Off the Loan?
Even if you plan to pay off a loan, paying attention to the amortization schedule is important. Understanding how much interest will be paid during the loan term shows that you are a responsible borrower. It will also help you realize the true loan costs when comparing offers from multiple lenders.
Amortization vs. Depreciation: Are they the Same?
Amortization and depreciation calculate the value of assets over time to reduce tax liability and apply tax deductions. However, they are not executed in the same way.
Amortization spreads an intangible asset’s cost over its useful life. For example, the cost of intangible assets (e.g. licenses, patents, trademarks, copyrights) will be expensed each period equally. If Company ABC obtains a $10,000 license that expires in 5 years, it will be labeled as a $2,000 amortization expense each year.
Depreciation expenses a fixed asset over its useful life so that the purchase price will match against the income it earns. For example, the value of tangible assets (e.g. buildings, vehicles, land) will decrease over time. If Company ABC purchases a $20,000 vehicle with an estimated usable life of 5 years, the depreciation expense each year equals $4,000.
What Is Positive Amortization and Negative Amortization?
Positive amortization and negative amortization are opposites. When it comes to positive amortization, borrowers gradually reduce the principal balance of their loan by making payments. Each monthly payment allocates a percentage toward principal and interest. Loans that experience positive amortization include fixed-rate mortgages, auto, and personal loans.
Negative amortization occurs when the principal balance of a loan increases because interest isn’t covered and a borrower doesn’t pay the interest portion of their loan payment. Instead of decreasing the loan amount, the principal balance increases for the amount of uncovered interest.
Examples of loans that experience negative amortization include adjustable-rate and graduated payment mortgages. For example, a borrower with an adjustable-rate mortgage chooses the amount of interest they pay. If their interest payment on the loan is $600 – and they elect to pay only $400 – then the $200 difference will be added to the loan’s principal balance.
What Is Amortization in Accounting?
Amortization in accounting is based on whether a loan, tangible asset, or intangible asset is being reported. Amortization details each mortgage payment’s principal and interest allocation and acts similarly to depreciation for the different asset types.
Where Is Amortization on the Balance Sheet?
If they have an exact value and useful lifespan, the amortization of intangible assets is found on the balance sheet under the assets section. The balance sheet will define the amortization expense (which will be deducted from all other listed assets to find total assets).
Is Amortization a Non-Cash Expense?
Amortization is a non-cash expense because it does not involve a tangible transaction – but it still impacts net income. These intangible assets depreciate and need to be reflected in a company’s financial statements.