Amortization is the process of spreading out a loan into a series of fixed payments over time. You’ll be paying off the loan’s interest and principal in different amounts each month, although your total payment remains equal each period.
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What is Amortization?
Amortization is an accounting technique used to lower the cost value of a finite life or intangible asset. The word derives from the Latin amortisus, meaning “dead.” In accrual accounting, businesses spread the cost of long-term assets, such as property or equipment, over the years they are used. The periodic amortization payments are recorded as expenses on the company’s income statement.
The goal of amortization is to charge the full cost of an asset to expense during its useful life in a systematic and rational manner. This expensing method is used for intangible assets with a definite life, such as patents and copyrights, as well as for certain fixed assets. It results in lower expenses in the early years of an asset’s life when it tends to be most valuable and higher expenses in later years when it has been depreciated.
How Amortization Works
Loan amortization is the process of repaying a loan in equal installments over its life span. The amount of each installment remains constant, but the proportion of interest to principal changes over time. At the beginning of the loan, most of each payment is applied to interest, and as the loan matures, more and more of each payment is applied to principal. The entire loan is paid off at the end of the loan term.
An amortization schedule is created when a borrower takes out a loan. It shows how much of the borrowed money has been paid back, including interest, at regular intervals over the life of the loan. The schedule also shows how much of each payment goes toward reducing the principal balance and how much goes toward paying the interest.
Amortization schedules are generally created for loans with fixed interest rates, so that the payment amount stays the same throughout the life of the loan. However, they can also be created for loans with variable interest rates. In this case, the payment amount will change along with the interest rate.
To create an amortization schedule, you need to know three things: the loan amount, the interest rate and the loan term. You can find these numbers on your loan paperwork or by contacting your lender.
With this information, you can create a table that shows each periodic payment and how it is applied to both principal and interest. At the end of the loan term, the table will show that the entire loan amount has been repaid.
You can create an amortization schedule yourself using a spreadsheet program such as Microsoft Excel. However, there are also many online calculators that will do it for you.
Use this calculator to find out how much your monthly loan payments will be, and how much you will pay in interest over the life of your loan.
Advantages of Amortization
Amortization has several advantages for both borrowers and lenders. For borrowers, amortization can provide a lower interest rate than other types of loans, such as credit cards or lines of credit. Amortization can also help borrowers keep their monthly payments manageable by spreading them out over the life of the loan.
For lenders, amortization helps to ensure that they will receive regular payments on a loan over its lifetime. Amortized loans are also less likely to go into default than other types of loans, which can help to minimize losses for lenders.
Disadvantages of Amortization
While amortization can be a great way to manage your loan payments and keep them affordable, there are some potential disadvantages to consider as well. One of the biggest drawbacks is that you may end up paying more interest over the life of the loan if you have a longer term. This is because the interest is spread out over a longer period of time, so you will accrue more interest even though your monthly payments may be lower.
Another potential disadvantage is that, depending on the terms of your loan, you may not be able to make additional payments or pay off the loan early without penalty. This means that you could end up paying more in interest than you would have if you had a different type of loan. Make sure to read the terms of your loan carefully before you sign any paperwork to make sure you understand all of the potential drawbacks.
Amortization vs. Depreciation
Amortization and depreciation are often used interchangeably, but there are some key differences between the two. Amortization is typically used in the context of loan repayments, while depreciation is used in the context of business expenses and property value.
Amortization is the process of spreading out a loan into equal payments over time. The length of time over which the loan is amortized can vary, but it is typically shorter than the total terms of the loan. For example, a 30-year mortgage can be amortized over 15 years. This means that each payment will be higher, but the total interest paid over the life of the loan will be lower.
Depreciation is the process of spreading out the cost of an asset over its useful life. The length of time over which an asset is depreciated can vary, but it is typically longer than the term of a loan. For example, a building may be depreciated over 40 years. This means that each year, the amount of depreciation expense will be lower, but the total depreciation expense will be higher.