What Is The Amortization and How Does It Work
Did you know that the word amortization means ‘kill’? So, when used in a financial context, amortization means the process of killing and erasing off a debt.
What is the meaning of amortization?
Amortization is a method of reducing the book value of a loan or intangible asset over time. On an asset, amortization is similar to depreciation. A loan’s amortization is the process of deferring repayment.
The term “amortization” describes two distinct circumstances. First, amortization is a method of paying down debt over time by making regular principal and interest payments. An amortization schedule is used to lower the present loan debt.
Second, for accounting and tax reasons, amortization can refer to the spreading out of capital costs connected with intangible assets over a specific period—typically the asset’s useful life.
Importance of Amortization
Amortization is essential in helping organizations realize the benefits and estimate expenses over time. In the case of debt repayment, the amortization schedule shows how much of a loan payment is interest and how much is the principal repayment.
This can be advantageous for tax purposes, such as deducting interest payments.
Amortizing intangible assets is particularly important since it reduces a company’s tax liability and, as a result, its tax burden while simultaneously providing investors with a better picture of its underlying profitability.
Amortization Of A Loan
Amortization is the process where you pay off your loans over a period of months in regular interest and principal payments that are enough to pay off the loan in full by the end of its term.
Early in the loan, a bigger percentage of the flat monthly payment goes toward interest, but as the term progresses, a more significant portion of the payment goes toward the loan’s principal.
You may use financial calculators, Microsoft Excel, and online amortization calculators to calculate amortization. The outstanding loan balance is the first item on the repayment plan. The interest payment is determined by multiplying the monthly interest rate (annual interest divided by 12) by the outstanding loan balance to arrive at the monthly payment amount. The entire monthly payment (a fixed sum) minus the interest of that month equals the amount that goes for principal repayment.
The outstanding loan balance for the next month is computed by subtracting the previous month’s outstanding loan balance from the preceding principal payment. The interest payment is computed using the new outstanding balance. The procedure repeats until all principal payments are completed, and the loan balance is zero at the end of the cycle.
Calculation of Amortization of Loans
Here’s the formula to calculate monthly principal on an amortized loan:
Monthly Principal Payment= Total Monthly Payment−(Outstanding Loan Balance × Interest Rate/12 Months)
Usually, when you get a loan, you know how much you’ll pay each month. If you’re trying to estimate or analyze monthly installments based on a set of variables like loan amount and interest rate, you’ll probably need to compute the monthly payment as well. For any reason, you might need to figure out how much you’ll pay each month.
Total Payment = Loan Amount * [{(i*1+i/n)/(1+i/n)}-1]
Where i is the monthly interest
And n is the number of payments.
For example, the loan amount is Rs. 5,00,000 with an interest rate of 8% p.a. for ten years. To find out the monthly interest rate, you need to divide the annual interest rate by 12. For instance, if the interest rate is 8%, then the monthly interest rate would be 8%/12 = 0.67%
If you want to find the number of payments, you simply need to multiply the number of years of the loan term into 12. So, if your loan term is ten years, the number of payments would be 120.
In this case, the monthly payment that needs to be made is Rs. 6,066. To calculate the interest portion in the first month’s EMI, we need to use the formula to figure out the monthly principal amount.
= 6,066 –(500000*0.67%)
=Rs.2,733
We need to subtract the principal paid from the initial principal to calculate the outstanding principal amount.
Here’s what the amortization schedule would look like for the first few months.
|
Month and Year
|
Starting Balance
|
Interest Paid
|
Principal Paid
|
EMI
|
Outstanding Principal Balance
|
|---|---|---|---|---|---|
|
Mar
|
5,00,000
|
3333
|
2,733
|
6,066
|
4,97,267
|
|
April
|
4,97,267
|
3315
|
2,751
|
6,066
|
4,94,516
|
|
Apr
|
4,94,516
|
3297
|
2,769
|
6,066
|
4,91,747
|
|
May
|
4,91,747
|
3278
|
2,788
|
6,066
|
4,88,960
|
|
May
|
4,88,960
|
3260
|
2,806
|
6,066
|
4,86,153
|
|
June
|
4,86,153
|
3241
|
2,825
|
6,066
|
4,83,328
|
|
Jun
|
4,83,328
|
3222
|
2,844
|
6,066
|
4,80,484
|
|
July
|
4,80,484
|
3203
|
2,863
|
6,066
|
4,77,622
|
At the end of 10 years, the borrower would pay the entire principal amount.
Amortization Of Assets
Amortization can also be used to talk about the amortization of intangibles or non-physical assets, like patents. In this example, amortization refers to the process of depreciating the cost of an intangible asset over the asset’s expected lifetime. It calculates how much an intangible asset, such as goodwill, a patent, a trademark, or copyright, has been consumed.
Amortization is computed similarly to depreciation for tangible assets, including equipment, buildings, cars, and other assets susceptible to physical wear and tear and depletion of natural resources.
To make sure the cost of an asset is in line with how much money it makes in the same accounting period, businesses that amortise their costs over the same accounting period.
A corporation, for example, gains from the utilization of a long-term asset over some time. As a result, the expenditure is written off throughout the asset’s useful life.
Accounting and tax standards give accountants guidelines on how to account for asset depreciation over time. However, the amortization of intangible assets is a tad more difficult than tangible assets. The real cost and value of items like intellectual property and brand awareness are not constant, so it is potentially more challenging to measure.
Amortization vs Depreciation
Amortization and depreciation are both ways to figure out how much it costs to own an asset over time. However, the primary distinction is that amortization applies to intangible assets, whereas depreciation applies to tangible assets. Trademarks and patents are objects of intangible assets. Tangible assets include equipment, buildings, cars, and other assets that are susceptible to physical wear and tear.
Conclusion:
You might think that amortization is a complicated term and idea with complex rules and laws. But it is conceptually very simple, and you can understand it and practice the necessary steps to understand your loan repayment process when required. Now that you know the meaning of amortization, you should be able to find a few uses for it in your everyday life.
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