Definition: Amortization is a method of paying off debt by paying a smaller amount each month until the full amount is paid. In general, it is used when you have a loan or credit card balance that you can’t pay off in full at once without sacrificing other values in your life.
Amortization is simply the process of paying off an outstanding debt with interest over a set period. When you pay off a debt, the payment that you receive from the lender is called profit. In the simplest terms, amortization works by taking the profit earned on an outstanding balance and subtracting the amount that it cost to pay off the debt over time. This means that as your debt payments decrease, so does the value of your house, a car, and other investments.
Amortization helps extend the lifespan of investment and makes it unnecessary to pay more in interest throughout the life of the investment. In addition, by periodically reducing the value of an asset, lenders can pass along savings to borrowers while minimizing the risk that borrowers will default on their loans or draw down their investments too aggressively.
Amortization can be beneficial to an investor, but it can also be difficult to understand why a company needs to use it. As a borrower, you may be interested in understanding the process of amortization so that you can make an educated decision on whether amortization might be beneficial to you or not.
Amortization schedules are one of the chief methods lenders use to extend the life of a loan by charging an upfront fee instead of rewarding borrowers with interest. An amortization schedule determines how much of your remaining balance you must pay overtime as a fixed monthly payment. The longer you pay off your current balance, the easier it will be to achieve your repayment goals. Once your payments have been reduced to an affordable level, the lender will phase out the higher interest payments. If you have no other option to pay off your balance at this time, your lender may require you to pay interest on any remaining balance.
The formula to calculate the monthly principal due on an amortized loan:
Principal Payment = Total Monthly Payment – (Outstanding Loan Balance * (Interest Rate / 12 Months))
- The monthly principal payment is the minimum payment required to maintain the amortization in effect on the loan.
- The outstanding loan balance represents the remaining balance on loan at the close of each billing period.
- The interest rate represents the interest charged on loan during that billing period, and it will decrease as the loan becomes less amortized.
The time it takes to pay off the debt over time is known as the amortization period. The total amount of time included in this period can be divided into an upfront payment and an ongoing cost. The upfront payment is what you pay upfront to the lender when you take out the loan. This typically includes money upfront to cover transaction costs and employee compensation owed when working for the lender.
When a company purchases definite property (real estate, plant, equipment, any tangible asset), it usually bears the expense of capitalizing the asset. Amortization of intangibles occurs when the cost of an asset is reduced through time and, thus, profit is earned on an ongoing basis rather than consumed when an asset is acquired.
When a purchase is made on an intangible asset, such as a software license or subscription, some fees must be paid overtime. These payments are known as amortization or depreciation. As time passes without the cost being recovered, the asset is lost, and the remaining value of the asset becomes less than the amount paid to purchase it. Therefore, the price paid for the intangible asset needs to be reduced by reducing its worthwhile, satisfying creditors.
Amortization is valuable for businesses because it reduces the tax bill over time. However, it can be tricky to determine which expenses will justify the expense and which will not.
The amortization process can be applied to many types of assets. For example, it’s commonly used to finance manufacturing plants and equipment, real estate, equipment, homes, consumer goods, infrastructure, transportation services, and any other tangible or intangible asset class that requires long-term financing to remain profitable.
Amortization can be a time-efficient way to spread out the cost of an investment over several years. This can help in increasing your return on investment over time. However, it can be challenging to determine exactly how long it will take and what impact amortization will have on your capital structure. With any investment, there are certain risks and rewards that you should consider when determining if amortization is right for you.